COURT FILE NO.: 04-CL-5321

(02-CV-225823)

DATE: 20140404

ONTARIO

SUPERIOR COURT OF JUSTICE

(COMMERCIAL LIST)

BETWEEN:

Livent Inc., through its Special Receiver and Manager, Roman Doroniuk

Plaintiff

– and –

Deloitte & Touche and Deloitte & Touche LLP

Defendant

Peter F.C. Howard, Patrick O’Kelly, Jonathan Levy, and Aaron Kreaden, for the Plaintiff

John Lorn McDougall, Q.C., Brian Leonard, Matthew Fleming, and Jeremy C. Millard, for the Defendant

HEARD: April 15-19, 22-26, 29, 30; May 1-3, 6-9, 13-17, 21-24; June 3-7, 10-14, 17-21, 24-28; July 8, 9, 11, 15, 16, 23-25; September 9-13, 16, 17; and October 9-11, 15-17, 2013

GANS J.

Part I: Liability

1. Prologue
2. Synopsis
3. The Claim—Dramatic Theme
4. The Fraud
5. Globally
6. The Cast of Characters
7. The Details

i. Kickbacks

ii. Expense Rolls

iii. Amortization Issues

iv. Revenue Transactions

5. Framework of Legal Issues
6. Duty of Care
7. Standard of Care: What Was It?
8. The Cases
9. The Experts

i. Paul Regan

ii. Ken Froese

iii. David Yule

3. The Deloitte Partners

4. The CICA Handbook

5. The Deloitte Manuals

6. Standard of Care: Was It Met?

7. The Pre-1996 Audits

i. Generally

ii. PPC

iii. Reputation

iv. The DCC Debenture

v. Continuity and Knowledge of the Client’s Business

2. The 1996 Audit

i. Backdrop

ii. PPC

iii. Musicians’ Pension Surplus Receivables

iv. Revenue Transactions

v. Conclusion

3. The 1997 Audit

i. The Pantages Air Rights Agreement and the Now-Infamous Put

ii. Conclusion—Q3—1997

iii. The Infamous Put, Part Deux

iv. The Put Uncovered

v. Conclusion on the Put Investigation

vi. Other Matters—1997 Audit

vii. PPC

9. Tort Claim—Conclusion/Distillation
10. Breach of Contract—Conclusion

Part II: Corporate Identification Doctrine

1. Introduction

2. Genesis of Corporate Identification

3. Deloitte’s Position

4. Hart Building

5. Ex Turpi Causa

Part III: Damages

1. Introduction
2. First Principles
3. Applying the “But For” Test
4. The Experts
5. The Equation and the Math
6. The “Raw” Number
7. The Sliding Number
8. Limiting Principles
9. Remoteness/Proximate Cause
10. Contributory Negligence
11. Deepening Insolvency
12. Prolonged Corporate Life
13. U.S. Bar Orders
14. The Final Number
15. Interest and Costs

Acknowledgements

Appendices

Appendix A: Debt and Equity Financing, Livent, May 1993 to June 1998

Appendix B: Impact Charts

Part I: Liability

1. Prologue

[1] In 1968, Mel Brooks wrote and directed the sometimes outrageous film, The Producers. In this film, which Brooks reprised in a 2001 Broadway musical of the same name, the protagonist, Max Bialystock, created a scheme through which he was able to convince a coterie of unsuspecting individuals to invest in his deliberately ill-fated Broadway ventures. He did so on the strength of his self-styled reputation as the “King of Broadway”. He enlisted the support of his star-struck accountant, the nebbish Leo Blum, whose function was to, among other things, doctor the books of account of the productions. Regrettably for Bialystock and Blum, the play which they first produced—and which they hoped would sputter out on or shortly after opening night—became a resounding success. Their scheme failed miserably, resulting in their prosecution, conviction for fraud and ultimate incarceration.

[2] In 1989, Garth Drabinsky and his long-time trusted colleague and soon-to-be co-conspirator and fellow inmate, Myron Gottlieb, left Cineplex Odeon Corporation after mounting an unsuccessful takeover bid. Their stated intention was to create a new vertically-integrated venture, the Live Entertainment Corporation of Canada (“LECC”), with the live entertainment assets of Cineplex that they obtained in their much-heralded, though unceremonious, leave-taking. I am not persuaded on the evidence adduced during the 68-day trial before me—the latest installment of this seemingly endless saga[^1]—that Messrs. Drabinsky and Gottlieb set out to defraud the world, by which term I mean to include those who invested through equity or debt in their enterprises. In retrospect, however, it would seem that the consequences of their actions were almost preordained. Put otherwise, much like the intended actions of Messrs. Bialystock and Blum, Drabinsky and Gottlieb ended up separating countless individuals and corporations, of varying degrees of sophistication, from significant sums, and later found themselves being charged, convicted of fraud and ultimately incarcerated.[^2]

[3] As a consequence of their actions Deloitte & Touche (“Deloitte”)[^3] and, in particular, certain of the Firm’s senior partners, became casualties of a monumental fraud that followed from the Drabinsky and Gottlieb “productions” and a fraud which still reverberates around the business and arts community of this country and south of the border today.

[4] Deloitte was first engaged as auditor of MyGar Partnership (“MyGar”) for the year ended December 31, 1989. It continued in that capacity for each fiscal year, to December 31, 1992. It was thereafter engaged to, among other things, perform the annual audits for the successor entity, Live Entertainment of Canada Inc. (“Livent”[^4]), a role in which it continued until Livent sought protection under the Companies’ Creditors Arrangement Act[^5] (“CCAA”) in November 1998.

[5] At its simplest, this is an auditor’s negligence case in respect of the audits performed by Deloitte between 1992 and the second quarter of 1998, which Livent alleged were not carried out in accordance with generally accepted auditing standards (“GAAS”) and should not have resulted in “clean audit opinions”. Alas, this is anything but a simple case: it involves the application of sophisticated legal and accounting principles to complicated facts.

2. Synopsis

[6] Gottlieb and Drabinsky created MyGar in September 1989. Shortly thereafter, MyGar purchased all the assets and assumed certain of the liabilities of the live entertainment division of Cineplex, including the production Phantom of the Opera (“Phantom”) and the Pantages Theatre in downtown Toronto (“Pantages”). The acquisition was initially financed by a $60 million two-year credit facility which Drabinsky and Gottlieb obtained from and guaranteed to the Royal Bank of Canada (“RBC”). In addition, Gottlieb and Drabinsky were “credited” with capital contributions totaling some $7.8 million (presumably financed through their severance package from Cineplex). The entire operation was carried on through LECC, as the nominee corporation for MyGar. All the assets utilized in the Drabinsky-Gottlieb ventures were, as will be described later, “owned” by that corporation, the beneficial ownership of which remained, at least notionally, with Gottlieb and Drabinsky.

[7] MyGar seemingly flourished over the next several years, acquiring along the way “domestic and international theatrical stage rights and ancillary rights (including foreign licensing rights, merchandising rights, sponsorship rights and cast album rights)”.[^6] It realized box office and critical successes from its productions of Phantom, Joseph and the Amazing Technicolor Dreamcoat (“Joseph”) and Kiss of the Spider Woman—The Musical (“Kiss”) and was poised to launch its major new production Show Boat, under the direction of Harold Prince, in the fall of 1993. It owned and operated one live performance theatre, the Pantages, and would acquire interests in theatres in New York, Chicago and Vancouver. All of these activities were undertaken to ensure that it would be a large, if not the largest, vertically-integrated live theatrical entertainment company.[^7]

[8] In May 1993, Livent was formed as the vehicle through which Drabinsky and Gottlieb were going to make their initial public offering (“IPO”) in Canada. From a corporate perspective, Drabinsky and Gottlieb transferred all their interests in MyGar (including LECC) and all of the shares of a related company called MyGar Realty Inc. (“MyGar Realty”) to Livent in exchange for its common shares. Thereafter, Livent owned all the assets and assumed all the liabilities previously owned or owed by MyGar or MyGar Realty. The principal asset of the latter company was land adjacent to the Pantages Theatre in Toronto which was intended to be used for a proposed development referred to as “Pantages Place”.[^8]

[9] Livent filed the following the financial information with its IPO Prospectus,: (1) audited consolidated financial statements of MyGar for the three-year period ending December 31, 1992; (2) an audited balance sheet of MyGar Realty as at December 31, 1992; and (3) a consolidated forecast for Livent for the year ended December 31, 1993.

[10] In May 1995, Livent filed a Registration Statement with the United States Securities and Exchange Commission (“SEC”) as a precondition to listing its common shares on the NASDAQ exchange, the effective date for which was August 3, 1995. From time to time thereafter, until June 1998, Livent returned to the capital markets in Canada and the United States seeking financing through the issuance of notes, debentures and additional stock through both private and public offerings. These several offerings and underwritings are set out below in the table excerpted from the report of one of the damage experts, Ian Ratner, and attached as Appendix A to these Reasons.[^9] Over the five years from May 1993 to June 1998, inclusive, Livent went to the capital markets at least seven times. It raised Cdn. $77.5 million by share and warrant offerings, US $125 million through the issuance of senior unsecured debentures, and a further US $77 million by share offerings, $34 million of which was obtained through two separate private placements in the spring of 1998.[^10]

[11] As part of one of the last two mentioned private placements, Drabinsky and Gottlieb agreed to permit the new investors, Michael Ovitz (Lynx Ventures L.P.) and Roy Furman (Furman Selz Incorporated) to appoint part of a new management team, as a consequence of which they gave up some of the control of the day to day management of the operation. New management, in the person of Robert Webster, a former KPMG partner, was appointed as the Executive Vice President of Livent, reporting to the newly expanded Board of Directors, at the head of which was Furman, who performed double duty as the new Chairman and CEO.

[12] Shortly after his appointment, in early August 1998, Webster learned of “serious accounting irregularities” in the company’s financial records.[^11] The new board immediately issued press releases, disclosing, in summary, that the suggested irregularities involve significant improper recognition of revenue and a failure to record or the improper deferral and capitalization of expenses, all of which might have a significant impact on the previously issued financial statements of Livent. Drabinsky and Gottlieb were immediately suspended; KPMG was appointed to conduct an investigation; an announcement was made that there would likely be a restatement of the previously issued financial statements; and share trading on the TSX and NASDAQ was suspended. The new board continued to issue press releases throughout the month of August, updating the capital markets as the results of the investigation became apparent.

[13] The response to the news was swift. Multiple class actions were filed in the U.S. against, inter alia, Gottlieb and Drabinsky, Deloitte & Touche (Canada and the United States), past and present directors and officers, and Livent as a “nominal” defendant. Indeed, there were at least 12 such actions filed in the month of August 1998 alone. These actions, which were undertaken on behalf of the Livent noteholders and the Livent shareholders were ultimately consolidated into four actions, two on behalf of the noteholders and two on behalf of the shareholders (collectively referred to as the “US Actions”).[^12]

[14] PricewaterhouseCoopers (“PwC”) was retained as an independent accounting advisor for the Audit Committee on the re-audit, after Deloitte withdrew its clean audit opinions in respect of Livent’s financial statements for the 1996 and 1997 fiscal years. On November 18, 1998, Livent issued restated financial statements, audited again by Deloitte, for the years ended December 31, 1996 and 1997, as well as making several adjustments to the financial results in prior years.[^13]

[15] A snapshot of the reconciled net income (loss) as previously reported and subsequently restated for the years 1996 and 1997, is set out as follows:[^14]

Year ended December 31

( CDN $ Millions)

1997 1996

Net income (loss) as previously reported (44,131) $11,054

Reduction of performance and merchandising (2,398) (1,526)

revenue improperly recorded

Reduction of other revenues improperly recorded (23,262) (19,355)

Improper recording of operating costs (68) (4,303)

Improper recording of general and administrative (421) (440)

expenses

Operating costs improperly capitalized to (6,076) (3,129)

preproduction costs

Operating costs improperly capitalized to (4,648) ______

fixed assets

Change in amortization of preproduction costs

resulting from the proper recording of 1,056 (11,084)

preproduction costs

Change in depreciation resulting from the 105 (200)

proper recording of fixed assets

Consequential adjustment of income taxes (18,829) 10,067

Net loss as restated $(98,672) $(18,036)

As is evident from a review of the above table, the income swing was significant, if not staggering.

[16] With the release of the restated consolidated financial statements in mid-November 1998, Drabinsky and Gottlieb were dismissed for cause and sued for fraud and breach of fiduciary duty, and Livent voluntarily made a petition for bankruptcy protection under Chapter 11 of the United States Bankruptcy Code. On the next day, Livent filed for protection under the CCAA in Canada and Ernst & Young was appointed its monitor.[^15] Trading in the stock was resumed and, as might have been expected, its value fell from US $6.75 per share to US $0.28 per share.[^16]

[17] In September 1999, Livent was placed in receivership, and Ernst & Young was appointed receiver and manager of all property, assets, and the undertaking of Livent. In November 2001, Roman Doroniuk was appointed the Special Receiver and Manager of Livent[^17] in respect of, inter alia, a potential action against Deloitte. In due course he commenced the instant action in the name of Livent Inc. by Notice of Action dated February 28, 2002.[^18]

3. The Claim—Dramatic Theme

[18] The claim against Deloitte, as originally formulated in the 118-page Amended Statement of Claim (“Claim”) can best be understood from a summary of certain of the paragraphs buried deep in the body of the Claim.

[19] Paragraph 207 deals with the duty of care. It starts by claiming that “Deloitte and Deloitte U.S. owed a duty of care, in contract and in tort as well as a fiduciary duty, to Livent on behalf of its creditors, shareholders and other stakeholders”. By the end of trial, this claim had been narrowed considerably. Deloitte U.S. was dropped as a defendant, as was the claim that Deloitte owed Livent a fiduciary duty. Furthermore, the plaintiff eventually made it plain that it was not, in fact, asserting any duty to or on behalf of “stakeholders” in the enterprise that went beyond that described by the Supreme Court in Hercules Management Ltd. v. Ernst & Young,[^19] the parameters of which will be described in more detail below.

[20] Paragraph 207 goes on to claim that Deloitte owed a duty to ensure that Livent’s financial statements were reported in accordance with its own accounting policies and generally accepted accounting principles (“GAAP”). This duty was to be satisfied by performing audits of Livent’s books in accordance with GAAS and Deloitte’s own manuals. It was suggested that Deloitte represented that it would meet an exceptionally high standard of care—above the normal standards of the profession—and that it should be held to that exceptionally high standard. In the end, the latter point proved to be insignificant since I found that the Deloitte manuals upon which the argument was based did not provide guidance that was materially different than GAAS.

[21] In para. 208, the plaintiff pleaded that Livent’s “Original Statements” were all materially and fraudulently misstated at the time they were issued. These included the annual financial statements for 1993-97, the quarterly financial statements in 1996-98, the MyGar financial statements included in Livent’s IPO Prospectus, and a September 2, 1997 press release announcing an adjustment to Q2 financial statements.

[22] Paragraph 209 particularized the fraudulent activities that Deloitte ought to have detected. Generally, they can be grouped into four categories. First, the payment of false or inflated invoices to complicit third parties who would then provide kickbacks to Gottlieb and Drabinsky. Second, “expense rolls”, which involved moving expenses to different quarters or to different productions. Third, the improper transfer of preproduction costs between shows. Fourth, transactions that were disguised to look like sales of assets, but which were in substance loan arrangements. The final three categories of fraudulent activities were undertaken for the purpose of inflating Livent’s reported net income.

[23] In para. 210, Deloitte was alleged to have fallen below the standard of care by failing to follow GAAS and thereby detect and expose the fraud. Its alleged negligent issuance of unqualified opinions, in turn, deprived the honest directors and shareholders of the opportunity to put a stop to the fraud, and the losses eventually caused to the company by the fraud, at an earlier date.

[24] More particularly, in para. 212, the plaintiff went on to allege that Deloitte ought to have known that the Original Statements were materially false and misleading and that Deloitte should not have endorsed them by

(a) issuing unqualified audit opinions;

(b) failing to withdraw on a timely basis previously issued unqualified audit opinions;

(c) acquiescing to the misstatements contained in Livent’s press releases when Deloitte knew or ought to have known that they contained material omissions and misrepresentations;

(d) failing to resign as auditors on a timely basis and disclosing the reasons therefor;

(e) failing to further investigate potential material omissions and misstatements; and

(f) failing to separately disclose to the appropriate level of authority material omissions and potential misstatements of which they became aware.[^20]

[25] Livent further alleged that because Deloitte did not discover the fraudulent misstatements particularized in para. 212 of the Statement of Claim, the Firm effectively facilitated the continuance of the fraud. Drabinsky and Gottlieb were permitted to continue reporting inflated revenues, net income, total assets, and shareholder’s equity, which in turn permitted them to continue to access the capital markets.[^21] From a damages perspective, so the plaintiff’s theory goes, the lack of timely disclosure meant that the net realizable value of its remaining assets upon liquidation was less than it would have been had the fraud been discovered and disclosed earlier.

4. The Fraud

a. Globally

[26] Livent alleges that the Original Statements were all false and misleading and did not fairly represent the financial condition of the Company. As a consequence, none of the Original Statements was prepared in accordance with GAAP. I am not satisfied on the evidence, however, that the Original Statements contained any errors, material or otherwise, caused by an unintentional act or omission.[^22]

[27] On the contrary, it was Livent’s position throughout the trial that the Original Statements were replete with fraudulent statements and other “irregularities”[^23] created by management and others in concert with management. The means used to perpetrate the fraud included, among other things:

(i) the use of deception, such as manipulation, falsification or alteration of accounting records or documentation;

(ii) misrepresentation or intentional omission of events, transactions or other significant information; and

(iii) intentional misapplication of accounting principles relating to amount, classification, manner of presentation or disclosure.[^24]

b. The Cast of Characters

[28] The parties readily acknowledge that Livent was rife with fraud, which burrowed deep into the operation, involved senior management and extended well into most, if not all, levels of the accounting staff of the Company. During the trial, I heard that in addition to Drabinsky and Gottlieb, the knowing and willing participants in various aspects of the frauds included Robert Topol (Chief Operating Officer), Maria Messina (former Deloitte partner and Chief Financial Officer), Gord Eckstein (Senior Vice President of Finance), Jerald Banks (Livent’s General Counsel), Dan Brambilla (Director and Executive Vice President), and Bill Connor (Senior Vice President North American Touring).[^25]

[29] I also heard that at least four members of the accounting staff, including a former Manager at Deloitte, Chris Craib, also participated in the frauds and aided in the alteration of Livent’s books and records. They were assisted by Livent’s Manager of Information Services, Raymond Cheong, who modified Livent’s accounting software to, among other things, (i) allow entries to the general ledger to be reversed or unposted and then posted to a different account or to a different accounting period; and (ii) permit staff to change the date on selected invoices.[^26] It is undisputed that the purpose of these modifications was to conceal Livent’s accounting manipulations and to ensure that no trail existed which could be uncovered by Deloitte during the course of the audit.

[30] Furthermore, Deloitte asserts in its argument, that of the four directors of Livent who sat on its audit committee between 1995 and 1997, three (Gottlieb, Martin Goldfarb and Andrew Sarlos) participated, in some manner, in misleading the Firm.[^27] The only member of the audit committee who did not know anything about the frauds during the relevant time period was H. Garfield Emerson who was appointed to the audit committee in 1995 and became its Chair in 1997.[^28]

[31] In addition to those on the inside, several representatives of third party suppliers, consultants, or business associates and partners of Livent knowingly assisted in the frauds. These included Peter Kofman, President of Kofman Engineering; Roy Wayment, President of Execway Construction; John Wilner of LeDonne, Wilner & Weiner, Inc. (“LeDonne, Wilner”); and Len Gill and Robin Pullen of Echo Advertising (“Echo”). Deloitte argued that others who were engaged in certain revenue transactions (“Revenue Transactions”) were similarly involved in fraudulent activities or irregularities in concert with the management and other staff of Livent. More of that will be discussed when I review certain of the Revenue Transactions, on an individual basis, later in these reasons.

c. The Details

[32] It is common ground between the parties that the cast of characters described above made a concerted effort to conceal the accounting frauds and irregularities from Deloitte. There were essentially four categories into which the accounting irregularities fell: (a) kickbacks; (b) expense rolls; (c) amortization issues; and (d) Revenue Transactions.

i. Kickbacks

[33] Between the years 1991 – 1993, at the behest of Drabinsky and Gottlieb, Kofman Engineering and Execway Construction rendered false or inflated invoices to MyGar. When the invoices were discharged, the money received by Kofman and Wayment made its way back to Drabinsky and Gottlieb personally or to King Commodity Services Ltd., a company controlled by the two of them. Gottlieb and Drabinsky received approximately $7.5 million, directly or indirectly, during this period of time. I was told that the kickbacks were undertaken to permit Gottlieb and Drabinsky to receive money from MyGar in excess of the limits placed upon their “draws” under the RBC loan agreement.[^29] Evidently, each felt constrained to live on a monthly stipend of $75,000.

[34] Eckstein was aware of the kickbacks, but neither he nor Drabinsky and Gottlieb ever disclosed them to Deloitte. A significant percentage of the inflated amounts associated with theatre engineering investigation work for intended productions and the Pantages construction development were capitalized as assets on the books of LECC, and later in MyGar Realty, creating a significant distortion to the balance sheet of each from the early days of the operation and well before the date of the IPO.[^30]

ii. Expense Rolls

[35] As previously indicated, Cheong, the manager of Information Services, modified the software used by Livent to permit the reworking of entries in the accounting system. He was directed to do so by Eckstein with the concurrence of Gottlieb and Drabinsky. These changes permitted Eckstein and those who worked for him to manipulate expenses either by backing them out of a particular accounting period, from quarter to quarter or into another year end, or moving them into and charging them against other activities or productions. The changes to the software went undetected not only by Deloitte, but also by RBC and Coopers & Lybrand, the latter of which conducted a review of the books of LECC on behalf of RBC while the debt obligation of MyGar remained outstanding.

[36] The juggling of expenses was particularly rampant in relation to the recording of advertising charges incurred with LeDonne, Wilner (in New York and elsewhere) and Echo (in Toronto and other locales in Canada). I was told that at least 10 officers and employees of Livent were implicated in this aspect of the fraud.[^31]

iii. Amortization Issues

[37] The largest fraudulent activity in terms of dollar value undertaken by the Company concerned the manipulation of millions of dollars-worth of costs and expenses that fell under the general heading of preproduction costs (“PPC”). PPC included all costs incurred to mount a production prior to its opening, such as those costs associated with set design and construction, costume design and fabrication, pre-opening advertising and promotion, and salaries and fees paid to the cast, crew and musicians during rehearsals.

[38] Initially, Livent employed the “cost recovery method” in accounting for its investment in its stable of productions. This accounting policy was utilized by another large player in the live theater production business, namely, the Real Useful Group (“RUG”), an Anthony Lloyd Webber company, from which Livent received various production rights, including those in respect of its first signature production, Phantom. This amortization method permitted Livent to accelerate the amortization of its PPC and defer income recognition until all preproduction costs had been recouped.

[39] As Deloitte observed when a review of this policy was undertaken in early 1996, the cost recovery method had advantages of simplicity and conservatism since it avoided having to forecast “the length of, and the revenues from, a live theater production run”.[^32]

[40] While I was urged to speculate that the reason Drabinsky and Gottlieb adopted this policy in the early years of MyGar’s existence was to tax-shelter income generated from operations, or from their respective payouts from Cineplex, I am satisfied on the evidence that the choice of this accounting policy was, initially, reasonable in the circumstances. Livent ultimately changed its policy in 1996, retroactive to fiscal year 1995, to the “income forecasting method”, about which I will have more to say later.

[41] Regardless of the policy used, Livent was able to engage in the improper transfer of preproduction costs from specific shows to fixed assets or from show to show, and, in particular, from one show to another that had not as yet opened, all of which permitted the Company to amortize the PPC over an extended period of time, or avoid amortization in any particular period. The net effect of these activities was to overstate income for the period, which became the watchword of the operation from about 1994 on to early 1998.

[42] The plaintiff’s theory is that Deloitte should have undertaken a more rigorous analysis of PPC right from the beginning of the LECC undertaking and ultimately when and after Livent became a public issuer. Put otherwise, it is the plaintiff’s position that Deloitte failed to analyze the amounts of amortization taken in any particular year in accordance with its own audit plans and neglected to ensure that the PPC taken or deferred as a capitalized asset bore any resemblance to what was projected. This failure on the part of Deloitte, the plaintiff argues, resulted in an overstatement of income in all the years of MyGar and Livent’s operations, with the possible exception of 1997, and underscores the fact that Deloitte failed to conduct its audits in accordance with GAAS. To borrow the oft-repeated phrase found in the plaintiff’s written argument, had Deloitte done its job, it would have been able to “unravel the tapestry of lies that had been woven by Drabinsky and Gottlieb”,[^33] which proposition the plaintiff suggests applied particularly to Deloitte’s review of PPC.

iv. Revenue Transactions

[43] The end of 1995 was something of a watershed for Livent. The company had no less than six shows in varying stages of presentation. Show Boat had just opened, Phantom was in the waning stages of its glory days, Kiss was garnering critical acclaim but was not a resounding success at the box office, and Music of the Night was also not meeting expectations. Sunset Boulevard was an artistic and commercial disaster, which would mandate a wholesale write-down of millions in PPC. In addition, Livent had five other productions under development, including Ragtime. Furthermore, in the vain attempt to be a completely vertically integrated company, Livent was spending significant amounts acquiring and renovating the Lyric and Apollo Theaters in New York and the Oriental Theatre in Chicago. While revenue appeared to have gone up by some 25% from year end 1994 to year end 1995, the net income before taxes, as then reported, did not grow proportionately. The Livent ship was experiencing some rough waters.

[44] In an effort to buttress the bottom line, Livent, primarily on Gottlieb’s initiative, entered into a series of transactions, each of which involved the sale of Livent assets to third parties. From 30,000 feet, the Revenue Transactions included the sale of exclusive rights to arrange and schedule tours of Livent shows, the sale of interests in production rights of various Livent shows, the sale of sponsorship rights or naming rights associated with Livent theaters or productions, and the sale of certain lands and density rights associated with the redevelopment and expansion of the Pantages.[^34] In total, Livent purported to conclude, four Revenue Transactions in fiscal 1996 and five in fiscal 1997, permitting it to record around $40 million in income in those two years.

[45] While it is fair to say that Deloitte devoted a significant amount of “partner time” to analyzing the Revenue Transactions, it is also fair to say that Deloitte was misled about the true nature of the transactions. In essence, the transactions were not true sales of assets, but loan or financing agreements. Livent colluded with the purported purchasers to misrepresent the true nature of the transactions by concealing certain side agreements (“Side Agreements”), some oral and some written, from Deloitte. These Side Agreements described a completely different deal than that disclosed to Deloitte. In many instances, the Side Agreement permitted the “purchaser” to recover the payments made or to be made and to recover the purported investment, even if the shows proved unsuccessful. Again, at its simplest, when Deloitte was able to discover the true essence of the transactions during the re-audit, they were none of them outright sales of assets, but simply loan or financing agreements.

[46] The plaintiff argued that Deloitte breached its duty to Livent by allowing the transactions as presented to be included in the Original Statements and in failing to critically examine these transactions, which, “upon proper scrutiny, ought to have led to the revelation of the fraudulent schemes of Drabinsky and Gottlieb”.[^35]

5. Framework of Legal Issues

[47] As I alluded to before, there is a myriad of legal issues essential to the resolution of this case. Again, the action, at its simplest, is one of negligence and/or breach of contract, by which latter term I mean the negligent performance of Deloitte’s contract for service.[^36] For purposes of this preliminary analysis, and because the case was argued by both sides primarily as an action in negligence, I am going to set out the principles applicable to the tort action first and then deal with any additional considerations introduced by the contract. Counsel for Livent acknowledged during argument that the damages on either front would be identical. That concession notwithstanding, I have come to the same conclusion, which will be developed (much) later in these Reasons.

[48] To succeed, the plaintiff has to establish that Livent was owed a duty of care, that there was a breach of the appropriate standard of care, that compensable damages resulted from this deviation from the appropriate standard of care, and that the damages complained of were factually and legally caused by the negligence or breach of contract of the defendant.[^37] At this stage of the decision, I will restrict my comments to the first two of these elements, namely whether Deloitte owed the plaintiff a duty of care and whether there was a breach of that duty.

6. Duty of Care

[49] The duty question can be answered in the affirmative without too much difficulty. The starting point is to be found in the statutory framework within which Livent functioned. Livent, as an OBCA company, was obliged to have an auditor, appointed by the shareholders annually, to prepare a report on the financial statements of management. The function of the auditor is to determine whether the financial statements “present fairly, in all material respects, the financial position of the company … in accordance with generally accepted accounting principles in Canada”.[^38] In addition, as a “reporting issuer” under the Securities Act, Livent was obliged to file its financial statements accompanied by a report of its auditor that the statements were prepared in accordance with GAAS.[^39] Finally, because Livent was listed in the U.S. on NASDAQ, it was similarly obliged to have audited financial statements.[^40]

[50] While many jurists have struggled with the test for determining whether a person owes a duty of care to another in a negligence case, which is a two-part test repeatedly articulated in the case law,[^41] in the wake of the Supreme Court of Canada (“SCC”) decision in Hercules there can be little doubt that auditors owe a duty of care to the company for the benefit of the corporate collective, the shareholders. In coming to this conclusion, the SCC adopted the following passage from the decision of Lord Oliver in Caparo Industries plc. v. Dickman:

It is the auditors’ function to ensure, so far as possible, that the financial information as to the company’s affairs prepared by the directors accurately reflects the company’s position in order, first, to protect the company itself from the consequences of undetected errors or, possibly, wrongdoing … and, secondly, to provide shareholders with reliable intelligence for the purpose of enabling them to scrutinise the conduct of the company’s affairs and to exercise their collective powers to reward or control or remove those to whom that conduct has been confided.[^42]

The above conclusion was heralded in an earlier decision of Farley J. in Roman Corp. Ltd. v. Peat Marwick Thorne:

It would appear that as a matter of law the only purpose for which shareholders receive an auditor’s report is to provide the shareholders with information for the purpose of overseeing the management and affairs of the corporation and not for the purpose of guiding personal investment decisions or personal speculation with a view to profit.[^43]

[51] While I am satisfied that Deloitte owed a duty of care to Livent for the ultimate benefit of its shareholders, it remains to determine the nature and extent of that duty. Both in oral and in written argument, Mr. Howard on behalf of Livent attempted to reduce the duty to what he suggested was its lowest common denominator, namely, a duty not to provide a clean opinion on materially misstated financial statements.[^44] In support of this proposition, he relied on, inter alia, the decision of Mr. Justice LeBlanc of the Nova Scotia Supreme Court in Sydney Cooperative Society Ltd v. Coopers & Lybrand and the cases therein referred to.[^45] While he impressed upon me the necessity of distinguishing between the “duty”, on the one hand, and the “standard of care” on the other, I am not sure that throughout the course of his argument, he did not conflate the two concepts. But I am persuaded, however, that the Howard definition of duty defines the concept too narrowly.

[52] In considering the appropriate legal duty of care, I found the excerpts from the text, The External Audit by R.J. Anderson FCA, to be most instructive since the author attempts to compare the professional concept of due care, which is defined by the Rules of Professional Conduct and by GAAS, with the legal standard of care found in the cases. Mr. Anderson acknowledged that the two concepts are not necessarily inconsistent and bear a close relationship one with the other. He draws comfort from the American Institute of Certified Public Accountants (“AICPA”) Statement on Auditing Standards, No.1, which provides as follows:

Every man who offers his service to another and is employed assumes the duty to exercise in the employment such skill as he possesses with reasonable care and diligence. In all these employments where peculiar skill is prerequisite, if one offers his service, he is understood as holding himself out to the public as possessing the degree of skill commonly possessed by others in the same employment ... But no man, whether skilled or unskilled, undertakes that the task he assumes shall be performed successfully, and without fault or error. He undertakes for good faith and integrity, but not for infallibility, and he is liable to his employer for negligence, bad faith, or dishonesty, but not for losses consequent upon pure errors of judgment.[^46]

7. Standard of Care: What Was It?

a. The Cases

[53] When R.J. Anderson discusses whether or not a breach of legal duty had taken place, he noted, quite rightly, that this analysis first required defining the applicable standard of care. He observed that this challenge was to be gauged against the backdrop of the following propositions:

Professionals are required not only to exercise care in what they do, but also to possess a minimum standard of specialized knowledge and ability. In defining this standard, the law looks neither to the highest nor the lowest standards which exist in the profession, but rather to the skill and learning commonly possessed by members of the profession.[^47]

[54] I agree with the Defendant that the standard of care owed by an accountant varies in degree, depending on the nature of the service provided. However, I do not accept the statement that the “general standard for all tasks is that of a ‘reasonably competent and cautious’ accountant”.[^48] Respectfully, that quotation, which is attributed to Matheson J.’s decision in Tannereye Ltd. v. Hansen, was taken out of context. The actual quotation is as follows:

The standard of care owed by an accountant to his client may vary in degree, depending upon the services provided. However, the minimum standard required for all tasks appears to be that of a “reasonably competent and cautious” accountant generally.[^49]

Circumstances may dictate that more than the minimum standard is required.

[55] Furthermore, I am not persuaded that the standard of care applicable to auditors in 1990s Canada is limited to that described in the two nineteenth-century English cases relied on by Deloitte, namely Re London & General Bank (No. 2)[^50] and Re Kingston Cotton Mill Co. (No. 2).[^51]

[56] Counsel for Deloitte have excerpted and underscored a passage from the speech of Lord Lindley, in the former case, and from the speech of Lord Lopes in the latter case, which they suggest provide the lens through which auditors’ negligence cases should be viewed, particularly where an auditor relied on fraudulent representations of management, as in the situation at hand:

Lord Lindley:

An auditor, however, is not bound to do more than exercise reasonable care and skill in making inquiries and investigations. He is not an insurer; he does not guarantee that the books do correctly shew the true position of the company’s affairs; he does not even guarantee that his balance-sheet is accurate according to the books of the company. If he did, he would be responsible for error on his part, even if he were himself deceived without any want of reasonable care on his part, say, by the fraudulent concealment of a book from him. His obligation is not so onerous as this. … What is reasonable care in any particular case must depend upon the circumstances of that case. Where there is nothing to excite suspicion very little inquiry will be reasonably sufficient, and in practice I believe business men select a few cases at haphazard, see that they are right, and assume that others like them are correct also. Where suspicion is aroused more care is obviously necessary; but, still, an auditor is not bound to exercise more than reasonable care and skill, even in a case of suspicion, and he is perfectly justified in acting on the opinion of an expert where special knowledge is required.[^52]

Lord Lopes:

It is the duty of an auditor to bring to bear on the work he has to perform that skill, care, and caution which a reasonably competent, careful, and cautious auditor would use. What is reasonable skill, care, and caution must depend on the particular circumstances of each case. An auditor is not bound to be a detective, or, as was said, to approach his work with suspicion or with a foregone conclusion that there is something wrong. He is a watch-dog, but not a bloodhound. He is justified in believing tried servants of the company in whom confidence is placed by the company. He is entitled to assume that they are honest, and to rely upon their representations, provided he takes reasonable care. If there is anything calculated to excite suspicion he should probe it to the bottom; but in the absence of anything of that kind he is only bound to be reasonably cautious and careful.[^53]

[57] While those cases may have been the progenitor for the analysis that is brought to bear in auditors’ negligence cases, in my view, the law has changed significantly since that bygone era. The cases that counsel for Deloitte cited thereafter, but for McEachern C.J.S.C.’s decision in Revelstoke Credit Union v. Miller,[^54] do not capture the obligations of auditors that existed at the close of the last century around the time of the Livent audits.

[58] That said, I hasten to observe that when the subject Livent audits were undertaken, the standard of care had not moved anywhere near the standard expressed in either Public Company Accounting Reform and Investor Protection Act (in the United States Senate) or Corporate and Auditing Accountability and Responsibility Act (in the House of Representatives), more commonly referred to as the Sarbanes-Oxley legislation, passed in the wake of the corporate and accounting scandals of the late 1990s, including those affecting Enron, Tyco International, Adelphia, Peregrine Systems and WorldCom.

[59] What then is the standard of care that should be applied? In my view, the following excerpts from three cases, referred to in the decision of my colleague McKinnon J. in Capital Community Credit Union Ltd v. BDO Dunwoody,[^55] correctly describe the legal principles that are applicable to the instant case.

[60] Lord Denning made the following observation in Fomento Ltd. v. Selsdon Fountain Pen Co., which I believe heralded the modern era of the standard of care of auditors:

What is the proper function of an auditor? It is said that he is bound only to verify the sum, the arithmetical conclusion, by reference to the books and all necessary vouching material and oral explanation; and that it is no part of his function to inquire whether an article is covered by patents or not. I think this is too narrow a view. An auditor is not to be confined to the mechanics of checking vouchers and making arithmetical computations. He is not to be written off as a professional “adder-upper and subtractor”. His vital task is, to take care to see that errors are not made, be they errors of computation, or errors of omission or commission, or downright untruths. To perform this task properly, he must come to it with an inquiring mind—not suspicious of dishonestly, I agree—but suspecting that someone may have made a mistake somewhere and that a check must be made to ensure that there has been none.[^56]

[61] Next in sequence is the decision of Moffitt J. in Pacific Acceptance Corporation v. Forsyth:

The legal duty, namely, to audit the accounts with reasonable skill and care, remains the same, but reasonableness and skill in auditing must bring to account and be directed towards the changed circumstances referred to. Reasonable skill and care calls for changed standards to meet changed conditions or changed understanding of dangers and in this sense standards are more exacting today than in 1896. This the audit profession has rightly accepted, and by change in emphasis in their procedures and in some changed procedures have acknowledged that due skill and care calls for some different approaches. It is not a question of the court requiring higher standards because the profession has adopted higher standards. It is a question of the court applying the law, which by its content expects such reasonable standards as will meet the circumstances of today, including modern conditions of business and knowledge concerning them. However, now as formerly, standards and practices adopted by the profession to meet current circumstances provide a sound guide to the court in determining what is reasonable.

The changes in accepted auditing standards are evidenced in that now, for some decades, in appropriate cases the auditor, after due inquiry and testing, relies on the company’s system of internal control and by this method may avoid the time and cost involved in endless “surface” checking of all transactions in favour of checking samples “in depth”. While this approach dispenses with some of the plodding and mechanical checks by audit clerks of former years, it calls for some care, skill and experience as the inquiries regarding the system and the selection, and to some degree the following through of appropriate samples, require an appreciation of the purpose of the procedures in relation to the company’s system of carrying out its activities and documenting its dealings. In this sense it might be said that the modern procedures call for more sophistication and higher standards on the part of those who perform the work. By way of further example, it would seem that due skill and care calls for a more searching and critical approach today on matters of stock and provision for bad and doubtful debts than it did fifty years ago, and to some extent even ten years ago.[^57]

[62] I now return to the decision of McEachern C.J.S.C. in Revelstoke, which I believe correctly encapsulated the standard of care that existed pre-Sarbanes-Oxley:

As is so often the case, there is great wisdom in the old authorities but the application of these cases depends upon many circumstances. Mr. Gibson, in a carefully constructed submission, referred to certain passages in the handbook published by the Institute of Chartered Accountants which are commonly described as generally accepted accounting standards (“G.A.A.S.”), and he urged me to conclude that an auditor is not liable if he accepts the assurances of a manager who has the complete trust of the directors provided he follows G.A.A.S.

A distinction must however be drawn between different kinds of cases. The typical case against an auditor is one where, without any reason to be suspicious of anyone, the auditor performs such tests and makes such enquiries as he thinks necessary, and then gives a favourable opinion on the financial statements without uncovering shortages of funds, security, or inventory which have been concealed by falsehood and deceit. In such cases, generally speaking, the auditor has not been liable if he followed G.A.A.S. in accordance with the standards of his profession in the class of work in which he was engaged. It is for this reason that most cases against auditors have failed—often to the surprise of businessmen—because the test that has been applied in most cases is not reasonable care but rather the standard of the profession.

As the accounting profession assumes an increasing importance in almost all financial matters it is likely, in my view, that the standards of the profession must be reexamined, as they have with other learned professions, and the obligation of enquiry is probably greater today than it was when the earlier cases were decided. Some dicta in these cases regarding the nature and scope of an auditor's duty seem to me to be out of date. Greater emphasis must be placed upon Lord Lindley's dictum that an auditor does not discharge his duty without making reasonable enquiries. Re Thomas Gerrard & Son Ltd., [1968] Ch. 455 at 475, [1967] 2 All E.R. 525, suggests the law is moving in this direction.

Another class of case is where an auditor who is following or attempting to follow G.A.A.S. has an opportunity to acquire or is exposed to knowledge or information which might affect his opinion but he fails to recognize and act on that information. Such an omission cannot, in my view, always be excused even if the auditor is following G.A.A.S.[^58]

[63] Indeed, the Revelstoke decision foreshadowed the results of a commission of inquiry (the “MacDonald Commission”) established by the Canadian Institute of Chartered Accountants (the “CICA”) in 1988 in the wake of the failures of the Northlands Bank and Canadian Commercial Bank in Alberta. The following excerpts from the MacDonald Commission’s report are very instructive:

The CICA Auditing Standards Committee should extend its guidance to audit procedures related to the discovery of management fraud. Since normal audit procedures provide a lower level of assurance with respect to the discovery of management fraud than they do with respect to the discovery of simple errors, the auditor should extend his or her work to give specific consideration to the possibility that such fraud may have occurred. If that consideration raises any question in the auditor’s mind about the validity of the traditional assumption of management honesty, additional audit procedures should be devised to provide additional assurance.

The auditor cannot and should not be held responsible for detecting all material frauds, particularly those involving careful concealment through forgery or collusion by members of management or management and third parties. Auditors nonetheless should be responsible for actively considering the potential for fraudulent financial reporting in a given audit engagement and for designing specific audit tests to recognize these risks.

Financial statements may be made instruments of management fraud by recording fictitious assets or omitting or understating liabilities. Financial statements may also be misleading as a result of improper valuations and estimates or a failure to adhere to GAAP. If done with an intention to deceive, these actions by management are also fraudulent, although there is not always a sharp line of division between mere optimism and fraudulent deception. Since the auditor’s duty is to report upon the financial statements, it is self-evident that the auditor must plan the audit program to catch fraudulent financial reporting and require appropriate correction of the financial statements.[^59]

b. The Experts

[64] As in all cases involving allegations of professional negligence, the Court had the benefit of hearing experts in the field opine on the appropriate standard of care. Three liability experts testified: D. Paul Regan on behalf of the plaintiff, and Ken Froese and David Yule on behalf of Deloitte. Additionally, the parties referred to the CICA Handbook and Deloitte Audit Manuals throughout the trial, all of which was aimed at helping me demystify the requisite standard of care.

i. Paul Regan

[65] Paul Regan is a Certified Public Accountant (“CPA”), licensed to practice in the State of California. He is chairman of a medium-size firm of CPAs located in the San Francisco area, Hemming Morse LLP, with which he has practised since 1975. The firm, which has a complement of 80 professionals, has a book of business that is heavily weighted to forensic accounting. While no doubt he worked in the auditing trenches for some time after his articles with Peat, Marwick, Mitchell & Co., which commenced on his graduating university in 1968, he has spent the bulk of his practice in the last 20 years as a fraud examiner and a professional witness in countless cases and depositions, as his curriculum vitae and his cross examination during the qualification stage of his evidence demonstrates.

[66] Deloitte urged me to reject Mr. Regan’s evidence entirely. Counsel argued that he had no relevant Canadian audit experience, nor any first-hand familiarity with the relevant CICA standards. They further suggested that his methodology and analysis were flawed and based on hindsight. Lastly, they argued that he did not provide fair, objective and nonpartisan expert evidence, as the Rules of Civil Procedure[^60] and the case law demand.

[67] Mr. Regan testified before me for almost 13 days. During the qualification stage in the beginning of May, I ruled that Regan could testify on the subject of proper auditing and accounting practices, without limitation as to any differences that might exist between Canadian and U.S. standards, but sounded a cautionary note that if I determined in the fullness of time that the differences sought to be established from the evidence in respect of Canadian and U.S. GAAS were more significant than originally thought, such might pose difficulties for the plaintiff in the final analysis. I have concluded that the differences in some of the GAAS principles, particularly in relation to the concept of professional skepticism and the treatment of misstatements, are more substantial than Mr. Regan suggested, although not to the extent that it warrants the rejection of his evidence in its entirety.

[68] I do not, however, accept Deloitte’s argument that Mr. Regan set out to purposefully mislead the court. As the plaintiff quite properly reminded me in its reply argument, I was satisfied that any lack of specificity in recalling the assistance Mr. Regan might have received from Messrs. Lipton Wiseman, a Canadian firm of accountants which is part of the network of firms associated with Mr. Regan’s own firm, during the preparation of his first report was more probably a function of an error committed by one of Mr. Regan’s associates, than anything else. I have no doubt that Mr. Regan realized that the Canadian information on the applicable standards obviously had to come from a Canadian accountant or auditor. And while I was mildly miffed by the fact that he did not completely “come clean” about the fact that his partner Mr. John was not a Canadian but a Scottish-qualified C.A., in the final analysis, I am not sure that this oversight was critical to my assessment of his overall evidence.

[69] Nor was I persuaded that Regan was not attempting to be fair or objective, particularly when he was advised by me of his responsibilities to assist the Court, respond to questions appropriately and not act as an advocate. While there is little doubt that the bulk of his practice is restricted to testifying as an expert, having testified before all manner of tribunals in the U.S., I am not persuaded that such should automatically disqualify him. I dare say that Ken Froese, one of Deloitte’s experts, seems to have adopted the same métier of late, and would not be disqualified on that basis alone.

[70] But I am concerned that Mr. Regan’s first report, and even his reply report, was rooted to some extent in incomplete information, if not information that might have been hand-selected by counsel or delivered to him and members of his firm piecemeal. Unlike the experts opposite, the background information received by Regan was provided him by counsel in the form of briefing books that spanned approximately 50 binders and was not delivered all at one time. Furthermore, he, unlike Messrs. Froese and Yule, did not have access to the entire Deloitte work papers organized by year and audit category, but was given material which I was told was organized by topic matter. It was difficult, therefore, for me to assess whether or not the manner in which the material was delivered to Hemming Morse LLP, was of any moment to his conclusions in the final analysis.

[71] I was, however, a tad uneasy about the fact that he was not able to reconstruct the audit, as it were, on a year-by-year basis in order to view the evidence in the same way it would have been viewed by the Deloitte engagement or review partners who would have been overseeing the field work by the managers and more junior staffers. In other words, a review by subject matter might have had the unintended consequence of skewing the analysis and might have provided Mr. Regan with a somewhat jaundiced view of the issues which he was later heard to criticize.

[72] I am also persuaded that Mr. Regan was operating from the vantage point of hindsight, if not engaged in the conduct of a forensic investigation as opposed to commenting on the adequacy of an audit, per se. The frailties of his methodology are reasonably captured by counsel for Deloitte in following excerpts from their written argument:

Regan began receiving documents from the Plaintiff’s counsel in April 2009 when he received copies of the pleadings, amongst other documents. He next received in June, July and August of 2009 packages of material including documents explaining how certain of the frauds at Livent were carried out and significantly, a binder with the restatement adjustments and restated financial statements. Thus, before receiving Deloitte’s actual work papers for the relevant period, he received details of the adjustments made to Livent’s financial statements identified as part of the re-audit and forensic investigation of KPMG, thereby enabling him and his team to work backward from the adjustments with the full benefit of hindsight.

Regan next received copies of some of the work papers but not in their original form. Instead, by way of example, on August 31 and September 1, 2009 he received several binders organized by topic including: “DCC Debenture Binder,” “NYPAC Deferred Costs Binder,” “PPC Phantom Tour Binder,” “PPC Joseph Binder,” “Pace Binder” and “Dewlim Binder,” amongst others.

Several of Regan’s binders related to preproduction costs (such as the Joseph, Phantom, Ragtime 1 and 2 and Showboat 1, 2 and 3 binders) each included, as the first page, a schedule of the adjustments made to those costs as part of the audit of the re-stated financial statements prepared by Plaintiff’s counsel. As Regan acknowledged, this permitted his team to work backward from the restatement. Several binders on other topics included documents from the restatement as the first documents in the binders, such as the Kofman-Execway binder, in order to help shape Regan’s evidence.

Had Regan been provided with all of the documents in Deloitte’s working papers (or considered all of the documents provided to him) it is not clear whether it would have impacted his opinion in view of his willingness to act as an advocate for the Plaintiff’s position. However, he did not even get the chance to consider all of the relevant documents in their original form because certain documents were withheld from him, while the documents he did receive were carefully organized to lead him to certain conclusions.[^61]

[73] In a review of Margaret MacMillan’s recently published book, The War That Ended Peace: The Road to 1914, Tim Cook made the following observation: “MacMillan cautions against reading history backward through time and resists the easy temptation to see all the puzzle pieces coming together in a kind of inevitability about the past”.[^62] At the risk of doing a disservice to Professor MacMillan’s thesis, I am not persuaded that Mr. Regan’s view of the matters in issue was not jaded by the end result.

[74] Interestingly enough, and for reasons that were never explained to me during his testimony, Mr. Regan did not refer to ss. 5000 and 5135 of the CICA Handbook in his first report. He testified that he “operationalized” those sections in his analysis at first instance and he did actually refer to them in his reply report. As will be discussed later in these reasons, each of these two sections expresses important guiding principles for the conduct of audits in Canada. I will consider the impact of this omission when discussing the evidence of Ken Froese and whether or not in the final analysis there is any difference in approach between Regan and Froese. But, in light of the important issues which the omitted sections address, I consider this omission to be of some significance and not one that can be readily rationalized.

[75] It is also important to observe that the Canadian standards are principles-based, while the American standards are rules-based; again, a difference that is more than a minor nuance, as an article by two of Mr. Regan’s partners demonstrates.[^63] As the evidence finally unfolded, I am of the view that there is a material difference between the U.S. and Canadian positions on the principle of professional skepticism.

[76] At the base of a Canadian audit is the “fundamental auditing postulate” that an auditor, when planning his audit, can assume management’s good faith in the preparation of the statements at first instance.[^64] The U.S. Standard on the other hand, assumes that management is neither honest nor dishonest.[^65] In Canada, the “benefit of the doubt” is extended to management once a misstatement is discovered by an auditor. Under the Canadian principles, a misstatement is prima facie considered an error, that is, a misstatement created through inadvertence, in the absence of evidence to the contrary. In contrast, under the U.S. standards, if a misstatement is identified, then “the auditor should consider whether such misstatements may be indicative of fraud”.[^66]

[77] In my opinion, these differences in approach could not but permeate Regan’s opinion and colour his evidence, from his analysis in respect of the audits undertaken from the early days of MyGar’s existence to the waning days of Livent’s operation at the time of the 1997 audit in April 1998. Ironically, notwithstanding his self-described “outrage” at the duplicity of Gottlieb and Drabinsky even in Livent’s early years, which he said might have lead him to decline any further engagement, Regan concluded as follows:

Had D&T complied with GAAS in its audits of the financial statements of Livent for the years ended December 31, 1996 and 1997, it should have detected the underlying fraud that resulted in the material misstatement of those financial statements, and had [D&T] complied with GAAS in its audits of Livent and its predecessor’s financial statements for the years ended December 31, 1991, 1992, 1994 and 1995 it may have detected the underlying financial fraud that resulted in the material misstatement of those financial statements.[^67]

[78] Mr. Regan was cross-examined on this statement on Day 10 of his testimony. I have reproduced the exchange below because of its importance to many of the issues:

Q. [Y]ou were asked to opine on whether, had D & T complied with GAAS in its audits of the financial statements of Livent, it should have detected the underlying fraud?

A. Correct.

Q. And as you just told us moments ago, I believe, that you concluded that Deloitte should have detected the fraud for the years ended December 31, 1996 and 1997?

A. Yes.

Q. And you also concluded that, had Deloitte complied with GAAS in its audits of Livent’s financial statements for each of the years ended December 31, 1991, 1992, 1994 and 1995, Deloitte may have detected the fraud?

A. Correct.

Q. You were not asked to opine on whether Deloitte may have discovered the fraud?

A. I don’t understand your question. I -- what I was asked is whether -- had Deloitte complied with GAAS, it should have detected the fraud. And my response was -- I bifurcated it into two sections; that it should have for '96 and '97; and it may have for the other years. That was my response to the assignment.

Q. So you volunteered the opinion that Deloitte may have detected the fraud for the years '91 through to '95?

A. Yes, sir.

Q. And so the answer to the question as to whether Deloitte should have detected the underlying fraud from ’91 to ’95, based on your conclusion, the answer to that question is “no”?

A. Could I hear your question again, please.

Q. You were asked whether Deloittes should have detected the fraud. You concluded that it should have detected the fraud in 1996 and 1997. The answer for those years is “yes”, Deloitte should have detected the fraud?

A. Yes.

Q. The answer to the question for 1991 through to 1995 is “no”?

A. That’s correct, I did not reach that conclusion.

THE COURT: Sorry. Now I’m confused, because I thought I had understood it when I read it. I apologize, Mr. Fleming. I thought I read that they might have detected fraud, '91 through '95; but they should have detected the fraud, '96, '97.

THE WITNESS: You’re correct.

THE COURT: That’s how I read that response.

THE WITNESS: You’re -- you’re exactly right. I agree with that.[^68]

ii. Ken Froese

[79] Mr. Froese is a Canadian-trained chartered accountant, having first received his designation while working with Doane Raymond in Nova Scotia in the early ‘80s and latterly with Grant Thornton (“GT”) both in the Maritimes and in Ontario. At GT, he worked out of the National Office, where he was assigned the task of assisting its various offices on GAAP and GAAS issues. As well, during several of his formative years as a partner with GT, he was engaged in the design of training programs for the firm and assisted in the provincial education of young accountants seeking qualification as CAs.

[80] He changed the focus of his practice after 1992, when he began devoting at least two thirds of his time to forensic accounting and investigation and the balance of his time to auditor performance issues, which included investigations on behalf of the ICAO or assisting counsel as a consultant or witness on matters before various tribunals, principally in Ontario and Quebec.

[81] No issue was taken with respect to his testimony on GAAP and GAAS issues associated with the Livent audits. Nevertheless, many of the same criticisms levelled against Mr. Regan, but for his knowledge of the applicable Canadian standards, were raised in argument in respect of the Froese evidence as it related to whether or not Deloitte had conducted the audits from 1995 to 1997 in accordance with GAAS.

[82] Simply put, I did not find Mr. Froese to be a fair, objective and non-partisan expert witness. In my view, he adopted the mantle of an advocate during the course of his evidence, and more than just occasionally. While never belligerent and always unfailingly polite, he refused to answer questions put to him by counsel in cross-examination in a straightforward and helpful manner if they undercut his thesis, namely that Deloitte had conducted the 1995, ‘96 and ‘97 audits in accordance with GAAS and should not have uncovered fraud or other irregularities in all the years in question.

[83] I must confess that I found certain of his responses to be frustrating, which at times diminished the helpfulness of his opinions in understanding some of the complex accounting and auditing issues. In my view, he fell victim to the harm that both sides cautioned against when each cited the decision of the Court of Appeal of Ontario in Carmen Alfano Family Trust v. Piersanti for their own purposes:

When courts have discussed the need for the independence of expert witnesses, they often have said that experts should not become advocates for the party or the positions of the party by whom they have been retained. It is not helpful to a court to have an expert simply parrot the position of the retaining client. Courts require more. The critical distinction is that the expert opinion should always be the result of the expert’s independent analysis and conclusion. While the opinion may support the client’s position, it should not be influenced as to form or content by the exigencies of the litigation or by pressure from the client. An expert’s report or evidence should not be a platform from which to argue the client’s case. As the trial judge in this case pointed out, “the fundamental principle in cases involving qualifications of experts is that the expert, although retained by the clients, assists the court.”[^69]

[84] Mr. Froese acknowledged that an expert’s approach to the issue of auditors’ negligence should not vary depending on the side for which he is called to testify; but I was disappointed to learn that he did not adopt that even-handed approach in the instant action. In contrast to what he did when he was retained by RSM Richter Inc., as Trustee in Bankruptcy in the Castor Holdings Ltd. (“Castor”) case, which was an action against Coopers & Lybrand Ltd. (“C&L”), in the instant case he neglected to mention or simply ignored certain Deloitte manuals, texts and Commission material that arguably undercut his conclusions. I thought that the omitted material, which proved to be at least worthy of consideration and inclusion by a GAAS expert, negatively impacted his credibility and usefulness as an “independent” expert. He was almost guilty of “cherry picking”, a concept recently commented upon by Moore J. in Frazer v. Haukioja.[^70]

[85] In addition to the foregoing, there were two concepts which were either down-played in his report and evidence-in-chief or not referenced at all: the first was the notion of “red flags” or warning signs; and the second was the concept of “audit by conversation”, or a reliance on representations by management without adequate audit evidence to support such representations. The notion of red flags was addressed in Mr. Froese’s report. But they were, at best, rationalized away in the instant case, while they featured prominently in the Castor report. The second concept, audit by conversation, which was mentioned several times in the Castor report, was singularly absent from his work-up of the Deloitte audits. Indeed, in cross, he would only acknowledge that avoiding audit by conversation was but “practical advice for auditors in doing an audit with professional skepticism”.[^71] I did not find this observation to be as much of a concession as it should have been.

iii. David Yule

[86] David Yule obtained his CA designation in 1961 and thereafter practiced with Clarkson Gordon and its present-day incarnation, Ernst & Young, until his retirement in 1997. He then assumed various executive and board positions with a variety corporations and institutions, including Datalex Corporation, the Deposit Insurance Corporation of Ontario, and the Shareholders Auditors Advisory Committee to the Superintendent of Financial Institutions for the Province of Ontario. His auditing experience was unquestioned and his expertise as a past chairman of the Auditing Standards Committee of the CICA added to his overall expertise. While he initially prepared a report that covered the audits of MyGar from 1989 to 1993 and thereafter Livent, to and including year-end 1997, his evidence before me was restricted to an opinion on the early years up to year-end 1994. No issue was taken by counsel for Livent as to his qualifications as an expert in GAAS and GAAP in Canada.

[87] In addition, and as is evident from the comments contained in the Stikeman Elliott written arguments, counsel did not have much to criticize Mr. Yule in respect of the manner in which he gave his evidence. But for certain matters which he had modest difficulty rationalizing, I found his evidence overall to be helpful, credible, and above all balanced.

c. The Deloitte Partners

[88] During the course of the trial, five former partners and one current partner of Deloitte testified before me (the “Deloitte Partners”). In addition, I heard from Maria Messina who, as a previously indicated, was a manager and partner at Deloitte before she moved to Livent. While each of the Deloitte Partners was called as a “fact” witness, and was not being put forward to provide me with an opinion on the appropriate standards, their evidence was replete with references to practice issues, which shed light on the applicable standards at the time, for better or for worse. It would be difficult for me now to divest myself of the information I received during the course of some of this evidence.

d. The CICA Handbook

[89] As previously indicated, several of the witnesses, including certain of the Deloitte partners and the experts, were confronted with excerpts from the CICA Handbook. Some time was spent parsing many of the sections to which reference was made. I think it is fair to say that both sides relied on various sections, as it suited their purposes. The sections to which reference was made included those which described concepts underlying the use of accounting principles in general purpose financial statement preparation, changes to accounting policies adopted by management, overarching GAAP issues, uncertainty associated with estimating or measuring, the preparation of interim financial reports and related-party transactions, to name but a few of the headings taken directly from the Handbook.

[90] While reference will be made to certain of the sections as each becomes relevant, it might be of some assistance to set out, verbatim, portions of two sections, which form part of the backdrop to an understanding of the applicable standards.

Section 5000 - Audit of Financial Statements - An Introduction

.01 The objective of an audit of financial statements is to express an opinion whether the financial statements present fairly, in all material respects, the financial position, results of operations and changes in financial position in accordance with generally accepted accounting principles, or in special circumstances another appropriate disclosed basis of accounting. Such an opinion is not an assurance as to the future viability of an entity nor an opinion as to the efficiency or effectiveness with which its operations, including internal control, have been conducted.

.02 The operations of an entity are under the control of management, which has the responsibility for the accurate recording of transactions and the preparation of financial statements in accordance with generally accepted accounting principles. These responsibilities include those related to internal control such as designing and maintaining accounting records, selecting and applying accounting policies, safeguarding assets and preventing and detecting error and fraud. An audit of the financial statements does not relieve management of its responsibilities. The auditor may make suggestions as to the form or content of the financial statements or the auditor may draft them in whole or in part, based on management’s accounting records. However, financial statements remain the representations of management.

.03 In the performance of an audit of financial statements, the auditor complies with generally accepted auditing standards, which (as set out in GENERALLY ACCEPTED AUDITING STANDARDS, paragraph 5100.02) relate to the auditor’s qualifications, the performance of the audit and the preparation of his or her report.

.04 The auditor performs the audit with an attitude of professional scepticism, and seeks reasonable assurance whether the financial statements are free of material misstatement. The auditor normally designs auditing procedures on the assumption of management’s good faith, and exercises professional judgment in determining the nature, extent and timing of those procedures, in evaluating their results and in assessing determinations made by management. Absolute assurance in auditing is not attainable as a result of such factors as the use of judgment, the use of testing, the inherent limitations of internal control and the fact that much of the evidence available to the auditor is persuasive rather than conclusive in nature.

.05 The assumption of management’s good faith is a fundamental auditing postulate. This assumption is normally necessary for an audit to be economically and operationally feasible. This assumption means, in the absence of evidence to the contrary, the auditor can accept accounting records and documentation as genuine and representations as complete and truthful. The assumption of management’s good faith is not a source of audit evidence nor a substitute for the requirement to obtain sufficient appropriate audit evidence to afford a reasonable basis to support the content of the auditor’s report.

.06 An attitude of professional scepticism means the auditor assesses the validity of evidence obtained and is alert to evidence which contradicts the assumption of management’s good faith. For example, the auditor is alert to evidence which may indicate accounting records and documentation have been altered or representations are false. It does not mean the auditor is obsessively sceptical or suspicious. Without an attitude of professional scepticism, the auditor may not be alert to circumstances which should lead him or her to be suspicious and he or she may then draw inappropriate conclusions from evidence gathered.

[Emphasis added]

Section 5135 - Auditor’s Responsibility to Detect and Communicate Misstatements

GENERAL ASSURANCE AND AUDITING – SECTION 5135

INTRODUCTIONS AND DEFINITIONS

.01 This Section deals with the auditor’s responsibility to detect material misstatements in an audit of financial statements or other financial information. Misstatements arise from “error” or “fraud and other irregularities”. This Section also sets out the auditor’s responsibility to communicate error or fraud detected in an audit of financial statements. Additional guidance on the content, documentation and timing of the communication of misstatements is provided in COMMUNICATION OF MATTERS IDENTIFIED DURING THE FINANCIAL AUDIT, Section 5750.

.02 The following definitions have been adopted for purposes of the Assurance and Related Services Sections of this Handbook.

(a) “Error” refers to an unintentional misstatement in financial statements, including an omission of amount or disclosure. Error may involve:

(i) a mistake in gathering or processing accounting data from which financial statements are prepared;

(ii) an incorrect accounting estimate arising from oversight or misinterpretation of facts; or

(iii) a mistake in the application of accounting principles relating to amount, classification, manner of presentation or disclosure.

(b) “Fraud and other irregularities” refers to an intentional misstatement in financial statements, including an omission of amount or disclosure, or to a misstatement arising from theft of the entity’s assets. Fraud also involves:

(i) the use of deception such as manipulation, falsification or alteration of accounting records or documentation;

(ii) misrepresentation or intentional omission of events, transactions or other significant information; or

(iii) intentional misapplication of accounting principles relating to amount, classification, manner of presentation or disclosure.

.03 The word fraud is used in this Section, although in practice the auditor will normally be concerned with a suspected rather than a proven fraud. Final determination of whether fraud has occurred will probably be made by a court of law.

.04 One of the factors distinguishing fraud from error is whether the underlying cause is intentional or unintentional. Intent is often difficult to determine, particularly in matters involving the use of judgment. In the absence of evidence to the contrary, a misstatement arising from management’s bias in selecting and applying accounting principles or in making accounting estimates would be considered an error.

PROFESSIONAL SCEPTICISM

.05 An attitude of professional scepticism is inherent in applying due care in accordance with the general standard (see GENERALLY ACCEPTED AUDITING STANDARDS, Section 5100). Such an attitude is necessary for proper consideration of factors which increase the risk of material misstatements and evaluation of evidence obtained. The auditor recognizes that conditions observed and evidence obtained, including information from previous audits, need to be evaluated with an attitude of professional scepticism to assess the risk of material misstatement. In particular, an attitude of professional scepticism means the auditor is alert to:

(a) factors which increase the risk of material misstatement. …

(b) circumstances which make him or her suspect the financial statements are materially misstated.

(c) conditions observed or evidence obtained which contradicts the assumption of management’s good faith. The auditor needs to be aware of factors which increase the possibility of management misrepresentation. For example, management can direct subordinates to record transactions or conceal information in a manner that can materially misstate financial statements.

.06 ►An audit of financial statements should be performed with an attitude of professional scepticism.

DETECTION OF MISSTATEMENTS

.07 The auditor’s assessment of inherent risk and control risk at the planning stage of the audit affects the nature, extent and timing of the procedures performed by the auditor. For example, higher risk assessments may cause the auditor to:

(a) perform audit procedures which provide more reliable evidence, such as confirmation obtained from a third party as compared to internal documentation obtained from the entity;

(b) expand the extent of the audit procedures performed; or

(c) apply audit procedures closer to or as of the balance sheet date.

.08 The auditor’s assessment of risk may also affect the staffing of the audit. A higher risk assessment would normally require more extensive supervision of assistants and/or assistants with more experience and training.

.09 Because the auditor maintains an attitude of professional scepticism when performing the audit, he or she will consider whether circumstances encountered indicate the possibility of a material misstatement existing in the financial statements. Examples of circumstances which, either individually or in combination, may make the auditor suspect misstatements exist are:

(a) Unrealistic time deadlines for audit completion imposed by management.

(b) Reluctance by management to engage in frank communication with appropriate third parties, such as regulators and bankers.

(c) Limitation in audit scope imposed by management.

(d) Identification of important matters not previously disclosed by management.

(e) Conflicting or unsatisfactory evidence provided by management or employees.

(f) Unusual documentary evidence such as handwritten alterations to documentation or handwritten documentation which would usually be electronically printed.

(g) Information provided unwillingly or after unreasonable delay.

(h) Seriously incomplete or inadequate accounting records.

(i) Unsupported transactions.

(j) Unusual transactions, by virtue of their nature, volume or complexity; particularly, if they occurred close to the year-end.

(k) Significant unreconciled differences between control accounts and subsidiary records or between physical count and the related account balance which were not appropriately investigated and corrected on a timely basis.

(l) Inadequate control over computer processing. For instance, too many processing errors or delays in processing results and reports.

(m) Significant differences from expectations disclosed by analytical procedures.

(n) Fewer confirmation responses than expected or significant differences revealed by confirmation responses.

.10 When circumstances exist which make the auditor suspect the financial statements are materially misstated, the assessment of the components of audit risk made at the planning stage of the audit may need to be revised and the nature, extent and timing of the auditor’s procedures may need to be reconsidered.

.11 If the auditor confirms or is unable to dispel the suspicion that the financial statements are materially misstated, he or she needs to consider the implications for the audit. …

.12 If the auditor confirms or is unable to dispel the suspicion that a fraudulent act has occurred, he or she needs to reconsider the reliability of evidence previously obtained since there may be doubts about the completeness and truthfulness of representations made and about the genuineness of accounting records and documentation. The auditor would also consider the possibility of collusion involving employees, management or third parties when reconsidering the reliability of evidence. If management is involved in fraud, it can direct subordinates to record fictitious transactions, create fictitious documentation or conceal information.

.13 If management, particularly at the highest level, is involved in fraud, the assumption of management’s good faith may be contradicted and the auditor may not be able to obtain the evidence necessary to complete the audit and report on the financial statements. In such circumstances, the auditor would consider obtaining legal advice about his or her contractual or statutory responsibilities and the appropriate course of action.

.14 ►The auditor may encounter circumstances which make him or her suspect the financial statements are materially misstated. In that event, the auditor should perform procedures to confirm or dispel that suspicion.

[91] I have reproduced only a portion of s. 5135 in the body of the judgment. However, it is worth paraphrasing some of the essential elements remaining in this section:

1. An auditor’s professional responsibility is discharged if an audit is conducted in accordance with GAAS.

2. In order to comply with GAAS, an auditor must design procedures to reduce the risk of not detecting material misstatements to an appropriately low level.

3. An audit does not guarantee that all material misstatements will be detected because of the use of judgment, the use of testing, inherent limitations on internal control and the fact that much of the evidence available to an auditor may be persuasive rather than conclusive.

4. An auditor is not an insurer and his report does not constitute a guarantee.

5. Compliance with GAAS is in some respects determined by the adequacy of the procedures undertaken in each case, and the suitability of the auditor’s report, based on the results of the procedures undertaken.

6. An auditor is less likely to detect material misstatements arising from fraud because fraud is generally accompanied by acts of deceit and concealment. Concealment can include the manipulation or falsification of accounting records or other documentation in an effort to mask the fact that the accounting records may not reflect the actual state of affairs of the company.

7. Accordingly, audit procedures that might be effective for detecting an unintentional misstatement may fall short of revealing intentional misstatements.

[92] While no doubt there are other sections that have to be considered, if not referenced in the instant case, s. 5140, “Knowledge of the Entity’s Business”, is important since it touches on many of the issues at play in the instant action. The salient points from s. 5140 may be paraphrased as follows:

1. Auditors must obtain and apply knowledge of the client’s business continuously and cumulatively. The knowledge obtained from the moment of the decision to accept the engagement, together with knowledge amassed over the course of the subsequent audit periods must be updated to ensure that it reflects the current circumstances of the client.

2. Knowledge obtained when planning an audit for the current period must be refined and supplemented as the audit progresses.

3. As a corollary, the planning and execution of an audit must reflect the auditor’s knowledge of the client.

4. Knowledge of the client’s business affects multiple components of the audit, including a determination of materiality levels, assessing the inherent risk associated with the audit, understanding and obtaining sufficient information in respect of the client’s internal controls, identifying the nature and sources of available audit evidence, designing audit procedures, and understanding the nature of the client’s business in order to better understand the substance of transactions.

5. Assessing whether sufficient appropriate audit evidence has been obtained, including evidence related to significant management representations.

[93] As an adjunct to this last mentioned section, an auditor is required to assess the information accumulated during the course the audit to determine whether or not decisions made during the planning stage remain appropriate. In this respect, an auditor has to be live to the issue of whether or not audit evidence sought has been obtained and whether it is sufficient in the circumstances to support the contents of the auditor’s report. Additionally, an auditor must use knowledge of the client’s business to assess the appropriateness of management’s selection and application of accounting principles. Last, but not least, the auditor must determine whether or not the financial statement presentation, namely, the form of the report, taken as a whole, is consistent with the auditor’s knowledge of the entity.

[94] The importance of this section, aspects of which permeated much of the evidence, sometimes in a different form, can be seen from the appendix that is attached by the CICA to this portion of the Handbook. Without reproducing it, the appendix fleshes out further subcategories, which instruct an auditor to identify the business environment of the client, the characteristics of ownership and management, and the operating characteristics of the client. Each of the last mentioned general headings provides the auditor with a virtual checklist of matters that have to be considered, almost routinely, and repeatedly if an auditor is to discharge its responsibility to conduct the audits for any particular period in accordance with GAAS.

e. The Deloitte Manuals

[95] The large accounting firms have national offices, the managers and partners of which provide support to the regional offices. The national offices are staffed by accountants and auditors with expertise in specialized areas, such as GAAS and GAAP. In addition, the national and international offices prepare manuals for the field staff, which, among other things, provide instruction, information and guidance on accounting and auditing issues. Deloitte not only had a national office, whose members were from time to time involved in the subject audits, but prepared manuals that were in use during the relevant time. I was told that there was a Canadian manual[^72] that was operative during the MyGar and early Livent years and an international manual[^73] that was introduced during the 1995 audit and used during the 1996 audit.

[96] I have no intention of reproducing the 346-page Deloitte Manual in the body of the judgment or even as an appendix. It is to be distinguished from the Canadian Manual which was a collection of the Firm policies that applied to all professionals in all services. From my review of the latter document, it does not appear to provide those undertaking an audit with any greater direction on the detection of fraud and error than is contained in the CICA Handbook. I find the following excerpt from the Deloitte Manual on the topics of fraud and error, however, to be of some significance since it is applicable to all audits conducted by Deloitte for the years subsequent to 1995:

Consideration of fraud and error

1.34 We need to plan and perform the audit with an attitude of professional skepticism, recognizing that circumstances may exist that cause the financial statements to be materially misstated as a result of fraud or error.

1.35 Owing to the inherent limitations of an audit and any system of internal control, there is a possibility that material misstatements resulting from fraud and, to a lesser extent, error may not be detected. Because fraud usually involves acts designed to conceal it, the risk of not detecting a material misstatement resulting from fraud is greater than one resulting from error.

1.36 Fraudulent acts include deliberate failure to record transactions, forgery of records and documents, and intentional misrepresentations to the engagement team. Fraud may include intentional acts by management or employees acting on behalf of the entity, as well as employee fraud where management or employees are involved in actions defrauding the entity.

1.37 We neither assume that management is dishonest nor assume unquestioned honesty. Rather, we exercise professional skepticism and recognize that conditions observed and evidential matter obtained, including information from prior audit engagements, need to be objectively evaluated to determine whether the financial statements are presented fairly in all material respects.

Fraud and Error

17.75 If the results of our tests of controls indicate the possible existence of fraud or error, we should consider the potential effect on the financial statements. If we believe the indicated fraud or error or risk thereof could have a material effect on the financial statements, we should perform appropriate modified or additional procedures.

17.76 The extent of such modified or additional procedures depends on our judgment of:

• Types of fraud and error indicated

• Likelihood of their occurrence

• Likelihood that a particular type of fraud or error could have a material effect on the financial statements.

17.77 Unless circumstances clearly indicate otherwise, we cannot assume that an instance of fraud or error is an isolated occurrence. If necessary, we need to adjust the nature, timing, and extent of planned substantive procedures.

17.78 Performing modified or additional procedures would ordinarily enable us to confirm or dispel a suspicion of fraud or error. Where suspicion of fraud or error is not dispelled by the results of modified or additional procedures, we discuss the matter with the appropriate level of management and consider whether it has been properly reflected or corrected in the financial statements. We also consider the possible impact on our report.

17.79 We also consider the implications of fraud and significant error in relation to other aspects of the audit engagement, particularly the reliability of management representations. In this regard, we reconsider our risk assessment and the validity of management representations, in case of fraud and error not detected by internal controls or not included in management representations.

17.80 The implications of particular instances of fraud or error discovered by us will depend on the relationship of the perpetration and concealment, if any, of the fraud or error to specific control procedures and the level of management or employees involved.

8. Standard of Care: Was It Met?

a. The Pre-1996 Audits

i. Generally

[97] The parties are in agreement that the standard of performance against which an auditor’s actions are to be gauged is to be determined by the Court. What then am I to draw from the evidence summarized above, particularly as it relates to the obligation to conduct the audits in accordance with GAAS and whether such would have resulted in the detection of fraud?

[98] Mr. Howard suggested that in the final analysis there was little to choose between the evidence of Froese and Regan in relation to the general standard of diligence and care to be brought to bear in an audit. It was his position that when the above cited sections of the Deloitte Manual were inserted into the equation, the seemingly high standards set by Regan were virtually congruent with the position of Froese, even though Howard quite rightly acknowledged that it is not just a matter of melding the CICA Handbook with the Deloitte Manual to arrive at the appropriate standard of care.

[99] I have already expressed my views on the evidence of each of these two gentlemen, neither of whose evidence I have rejected nor accepted in its entirety. In my view, and to repeat my conclusion, the Canadian and American approaches to professional skepticism and the detection of fraud and irregularities differed significantly to at least the end of audit year 1995. If it were otherwise, Deloitte would have been obliged to plan for the detection of intentional misstatements in all pre-1996 audits, which it did not,[^74] notwithstanding the recommendations contained in the MacDonald Commission report and the seeming concession made by Mr. Froese in cross-examination that such planning was necessary.[^75]

[100] All the evidence suggests, however, that the detection of fraud during the course of an audit is difficult even if the audit is conducted in accordance with GAAS. Indeed, the standard engagement letter used by Deloitte and signed by the client during the relevant period of time underscores this proposition:

It should be noted that an audit conducted in accordance with generally accepted auditing standards is based on selective tests. Because detailed examination is not performed on all transactions, there is a risk that material fraud or error may exist but not be detected.[^76]

[101] Cycling back to the plaintiff’s theory of liability and damages, had Deloitte detected and disclosed the fact that Livent’s Original Statements contained material misstatements as a result of fraud or other irregularities, its ability to access the capital markets would have been brought to a screeching halt. Implicit in this thesis is the notion that Deloitte would not have been able to issue an unqualified opinion in any year in which the fraud was detected. In addition, Deloitte would have had to report the matter first to the Audit Committee, in this case to its chairman, Emerson, who was basically the last honest man standing, whereupon the matter would have been disclosed to the non-Drabinsky-Gottlieb appointees of the Board and then to the regulators. This is precisely how the situation unfolded in early August 1998, and I have no reason to doubt that it would not have occurred in any of the years previous had the fraud been detected.

[102] Livent’s counsel takes the position that with respect to the audits up to and including 1992, there were at least 14 red flags that afforded Deloitte the opportunity “to unravel the tapestry of lies that had been woven by Drabinsky and Gottlieb by increasing their scepticism, questioning management’s good faith and/or arousing their suspicions that fraud may be the best explanation”.[^77] These transactions, to which plaintiff’s counsel repeatedly referred, included misrepresentations on the part of Gottlieb and Drabinsky that transcended the Kofman-Wayment kickbacks, the latter of which payments by all accounts would have been virtually impossible to detect.

[103] I digress to observe that several witnesses attempted to provide me with a primer on materiality and how that notion comes into play in the assessment of whether or not Deloitte discharged its obligation to conduct the audits in accordance with GAAS. I was told that the principle of materiality, which is conjoined with the further principle of “audit risk”, drives, in large measure, the nature, extent and timing of the audit procedures themselves. I was also told that both concepts are employed in the final stages of the audit, as well, when the auditor assesses whether or not management’s assertions that the financial statements are presented fairly in accordance with GAAP are correct. Underlying both principles is the understanding by auditors that the figures presented by management “are not necessarily precise and that the audit does not provide absolute assurance that the financial statements are not materially misstated”.[^78]

[104] At the risk of doing a disservice to these concepts, which are anything but easy to grasp, there is a point at which the cumulative dollar value of all the individual misstatements identified by the auditor is so great that the financial statements cannot be said to fairly present the financial affairs of the enterprise. At that point, the financial statements would be “materially misstated” and the auditor would be obliged not to endorse them with a clean opinion until and unless the client were to successfully reduce the cumulative dollar value of the misstatements to below the point of materiality. The test for whether a misstatement (or the aggregate of all misstatements) is material is whether “it is probable that the decision of a person who is relying on the financial statements, and who has a reasonable knowledge of business and economic activities (the user), would be changed or influenced by such misstatement or the aggregate of all misstatements”.[^79] This is not a test that admits of bright-line answers. There is a grey area between misstatements that are clearly material and those that are clearly immaterial. Determination of materiality is therefore a matter for the auditor’s professional judgment.

[105] With that explanation as the backdrop, the plaintiffs suggest that if the net income for the fiscal years ending 1993 – 1995 were adjusted for misstatements that Deloitte missed, net of tax, and were in excess of planning materiality, individually or in the aggregate, then the following would have been a more accurate representation of net income in the audit years under consideration:[^80]

Net Income (Loss) as:

Year

Originally Reported

Adjusted for Errors

1993

$7,807,922

$5,426,095

1994

5,835,077

3,332,936

1995

11,766,969

2,748,452

1996

11,053,702

(19,318,500)

1997

(44,130,869)

(89,814,090)

[106] I return to Regan’s conclusion that, while Deloitte should have uncovered the fraud in 1996 and 1997, he could only put it as high as Deloitte “may have” uncovered the fraud in the pre-1996 years. Both Froese and Yule were in agreement with the latter conclusion. Having regard to Regan’s starting position about the level of professional skepticism that he would bring to bear in the circumstances, which I found was too high a standard from a Canadian perspective, and at the risk of merging liability and causation principles, I think it is safe for me to conclude that the plaintiff did not cross the “balance of probabilities” finish line on the liability issue for these early audits.

[107] In other words, even if I were wrong and Deloitte did not meet the requisite standard of care during the 1993, ’94 and ’95 audits, I am not persuaded that the alleged breaches during those years caused any damage to Livent, an issue to which I will return in the damages portion of this judgment.

[108] But Deloitte, as best as I understand from its argument, did not reduce its position to the above “simplified” proposition about proof on a balance of probabilities even though Mr. Fleming, one of Deloitte’s counsel, developed this theme in his cross-examination of Mr. Regan, excerpted above. Therefore, I propose to touch on a few of the matters upon which the plaintiff led evidence and which occupied a significant portion of its multiple detailed facta. To do this analysis, I have appended as Appendix B to this judgment various tables (the “Impact Charts”) setting out by line item, the alleged errors and their impact on tax-adjusted net income, the final snapshot of which is depicted above.[^81]

ii. PPC

[109] From my review of the Impact Charts, it appears that the overwhelming bulk of the alleged errors, individually or collectively, were generated through increased amortization of PPC not initially taken. Increased PPC as an alleged error represented 85% of tax adjusted errors in 1993, 78% in 1994, and 73% in 1995. Without getting into the math, even these ratios overstate the alleged errors since the numbers are cumulative from one year to the next and include a reversal of some $4,557,528 of PPC previously reported for the Show Boat original preproduction costs as a result of the change in accounting policy effective as of year-end 1995. In other words, because of its retroactive change in accounting policy, Livent was able to “overstate” its net income in 1995, which Livent’s counsel suggests was done purposefully.

[110] Without detailing the evidence in respect of the debate surrounding the change in policy, the supposed rationale for same and whether or not it should have been done on a go-forward as opposed to a retroactive basis, suffice it to say that it was a policy change that was not done surreptitiously, and not without significant discussion with Deloitte and others, including Richard Ivey Business School accounting professor Ross Archibald. I am not satisfied, contrary to argument by Mr. O’Kelly on one of the many days that was devoted to this issue, that the plaintiff has established that the change in policy was another example of Gottlieb and Eckstein’s deceptive number-juggling. In my view, whether Deloitte was correct or not in permitting the change in policy to be implemented on a retrospective basis, if at all, was clearly a matter of judgment and was acceded to only after reasonable consideration.

[111] I am also not persuaded that for the years ending 1993-1995 Deloitte did not properly plan for and undertake reasonable procedures when auditing the PPC amortized and capitalized in any year. While there may be some argument that Deloitte missed or did not insist on the taking of increased amortization for Phantom and Joseph in the early years, it was live to the risks inherent in management evaluations and undertook a “tailored program” to safeguard against failure to comply with GAAS.

[112] I agree with Deloitte that the PPC issue in the pre-1996 period has to be considered in context. It is not as if significant amounts of PPC were not taken in any of the years in question.[^82] Indeed, when it was determined as it was, for example, in 1994 with Kiss, that the remaining PPC had to be taken since the show was destined for the trash heap of great theatrical ideas, close to $10 million was taken in that year. Furthermore, at this stage in the relationship, there was little if any evidence to suggest that Deloitte should have been on guard with the representations and judgment of front-line and back office management on the production side of the operation. To that extent, where the evidence of Mr. Regan on pre-1996 PPC conflicts with that of Mr. Yule, I accept the evidence of the latter over that of the former.

[113] This last observation carries me into three additional areas which clearly had an impact on the Regan take on some of the matters in issue, namely (a) the early reputation of Drabinsky and Gottlieb and initial due diligence of a “new client”; (b) the “DCC debenture”; and (c) the continuity and experience of the audit team.

iii. Reputation

[114] We now know that Drabinsky in particular, if not Gottlieb, was something of an enfant terrible as he was making a name for himself first at Cineplex and latterly at Livent. The plaintiff tried to lever their individual or collective reputations at the time of the creation of MyGar into a matter of accepted notoriety. To that end, counsel for the plaintiff attempted to introduce into evidence certain newspaper and magazine articles which suggested that Drabinsky and Gottlieb operated on, or very close to, the integrity line. I was not persuaded that the articles themselves should be received in evidence for the truth of their contents when the defendant’s witnesses to whom the articles were put had not seen them. The witnesses were also not prepared to acknowledge that they knew the integrity of management to be in question. Had the plaintiff wanted to establish the poor reputations of Drabinsky and Gottlieb, which it suggests were borderline disreputable, they could have easily called the Hon. Leo Kolber or Allen Karp Q.C., the Chair and CEO, respectively of Cineplex at the time of their ouster.

[115] Aaron Glassman, the first Deloitte partner who assumed the role of MyGar and Livent’s Engagement Partner and in later years became the Lead Client Services Partner (“LCSP”), was aware that Drabinsky and Gottlieb were aggressive in their approach to accounting matters and had been involved in a messy take-over fight. But he had not heard that either of them should be viewed with suspicion on the integrity front. Indeed, MyGar—i.e., Drabinsky and Gottlieb—came to Deloitte from C&L, and from a well-respected partner at that firm, and was introduced to Deloitte through Leonard Barkin, Glassman’s longstanding partner, who knew Gottlieb both on a business and social level and acted as the LCSP from 1989-1993, inclusive.

[116] The plaintiff attempted to persuade me that Glassman in particular and Deloitte in general failed to discharge their due diligence obligation when taking on this engagement, contrary to the provisions of the Deloitte Manual, if not the Handbook. I am not persuaded that this proposition is correct or that whatever standard existed in the late 1980s and early 1990s was not met by the discussions among partners. Furthermore, to demand anything further by way of due diligence would have set the bar too high in that era of professional engagements or retainers, particularly in a city such as Toronto, where the competition for business was fierce.

iv. The DCC Debenture

[117] I preface my remarks in respect of this transaction by observing that the evidence was anything but clear even though the parties concluded an Agreed Statement of Facts which set forth some, but not all, of the attendant constituent elements.[^83] But for the testimony of Aaron Glassman and Maria Messina,[^84] who were not involved in the transactions per se, I did not hear from any of the actual participants. In the final analysis, I was compelled to review, for the umpteenth time, some of the documents filed as part of the 16000 plus Joint Book of Documents, a task which, notwithstanding the hyperlinked facta of counsel, was not easy.[^85]

[118] In June 1990, LECC entered into an agreement with the City of Toronto (“Master Agreement”) which provided for the swap of lands that Drabinsky and Gottlieb intended to buy at the Bond/Dundas intersection in exchange for lands contiguous to the Pantages, which came to be known as the Victoria/Shuter lands. The Bond/Dundas lands were purchased in September 1990 for $7.875 million, with a down payment and a subsequent capital payment totaling approximately $1.1 million and the balance financed with two vendor take-back mortgages. Title was taken in the name of LECC, subject to a trust declaration in favour of Drabinsky and Gottlieb as the “undisclosed” beneficial owners. In late December 1991, the two partners, as equal shareholders, caused MyGar Realty Inc. to be incorporated. They immediately transferred the Bond/Dundas lands from LECC to MyGar Realty Inc., subject to a second declaration in favour of the same “undisclosed owners”, namely, Drabinsky and Gottlieb.

[119] In the middle of May 1991, LECC, as nominee for MyGar Partnership, entered into an Amending and Restating Loan Agreement with RBC, in which, among other covenants, it agreed that it would not enter into any debt agreement other than for debt incurred in the ordinary and normal course of its business (the “Negative Covenant”).[^86] At the end of May, LECC, again acting as nominee for MyGar Partnership, issued a debenture to DCC Equities Limited (“DCC”) for $5 million (“DCC Debenture”). Contemporaneously with its execution, Drabinsky and Gottlieb executed a Beneficial Owners Agreement and Guarantee in favour of DCC in which they pledged their respective interests in LECC and MyGar Partnership to cover the obligation under the DCC Debenture.[^87]

[120] In early March 1992, but on a date that was never really buttoned down on the evidence, LECC and RBC entered into an agreement “made as of December 31, 1991”, amending the May RBC Agreement.[^88] Included in this agreement was a paragraph which specifically exempted the DCC Debenture from the effects of the Negative Covenant. In other words, RBC acknowledged the obligation to DCC and gave approval to the transaction notwithstanding its “creation” a scant few weeks after the execution of the May RBC Agreement.

[121] The plaintiff takes the position that the DCC Debenture and the obligations arising thereunder were those of MyGar Partnership at the end of 1991 and should have been disclosed by management to Deloitte prior to the completion of the 1991 audit. In fact, the plaintiff argues that since management did not disclose this transaction to Deloitte before the completion of the 1991 audit, it specifically mislead the Firm by not coming clean on the deal during the relevant time and by signing a representation letter for that year which failed to disclose the DCC Debenture.

[122] On the plaintiff’s view of the evidence, the DCC Debenture was not discovered by Deloitte until during the preparation of the 1992 audit, in early 1993.[^89] It argues that this revelation, late as it was, amounted to anything but a frank disclosure. Furthermore, the full circumstances surrounding the DCC Debenture should have “outraged” Deloitte, as they did Regan, and should have raised their suspicions that Drabinsky and Gottlieb were playing fast and loose with their obligations of, among other things, full disclosure to the Firm as a precursor to the audit process.[^90]

[123] The Defendant argues, in spite of Glassman’s poor recollection of the subject, that Deloitte had been informed of the pending DCC Debenture transaction as early as November 1990, as the documents suggest.[^91] Furthermore, it is Deloitte’s position that there was nothing untoward about the transaction since the debt created as a consequence was not, in fact, an obligation of LECC/MyGar Partnership but was that of the “partners”, Drabinsky and Gottlieb, until the bank financing and the Negative Covenant had been renegotiated or some other arrangements had been put in place.

[124] I have struggled mightily with this transaction. I vacillate between the positions expressed by Regan, which, as I indicated, was one of outrage, and Yule, who was prepared to give the transaction a pass, and the arguments of counsel for each side. I am further troubled by the fact that no one at Deloitte thought to “follow the money” paid under the DCC Debenture, if in fact any payment was made, about which Mr. O’Kelly cautioned me on several occasions.

[125] In the final analysis, I prefer Mr. Yule’s take on this transaction over that which is propounded by Mr. Regan—and, indeed, by Mr. O’Kelly through his compelling and persuasive advocacy. I am satisfied, however, on a balance of probabilities that the Bond/Dundas land and the $5 million DCC debenture were beneficial assets and liabilities of Drabinsky and Gottlieb personally, as at December 31, 1991. They were subsequently transferred to MyGar Realty, as of December 24, 1991 and in the months following as a precursor of and to facilitate the IPO. Hence, they did not have to form part of the asset and liability mix of MyGar in 1991 and need not have been disclosed in the Original 1991 Statements.

[126] I am satisfied that RBC was in the loop on what was going on after the DCC Debenture was concluded at the relevant time and why. Had RBC thought that it was being played for a fool by the end of 1991, or as late as early March 1992, it would not have entered into the December Amending Agreement, and a further amending agreement in early May 1992, and in all probability would have called the loan under the May RBC Agreement. I am also satisfied that Deloitte was aware of the DCC Debenture by virtue of the fact that it apparently received a copy of the December Amending Agreement in early March 1992 before it completed the 1991 audit even though a copy of same was not to be found in its files. Glassman must have concluded that the DCC Debenture was the separate obligation of Gottlieb and Drabinsky even though, as I indicated, he has no present recollection of the details of the transaction.

[127] Whether or not Drabinsky and Gottlieb were merely keeping their options open until they determined what made the most sense from an economic, personal or corporate point of view is something about which I can only speculate. Furthermore, the various memos and letters penned by certain Davies, Ward and Beck lawyers, Livent’s counsel on the underwriting, in the months ramping up to the IPO are instructive in that regard.[^92] I am not, therefore, persuaded that the plaintiff has proven that Deloitte failed to conduct a proper of audit of this very complicated transaction in accordance with GAAS.

v. Continuity and Knowledge of the Client’s Business

[128] From time to time during his evidence, Mr. Regan took the position that the Deloitte audit team in all the years in question did not possess adequate technical training and proficiency in auditing. I do not recall hearing any evidence from him or seeing anything in his report that would permit him to come to this conclusion absent any knowledge of the training, education and experience of those who staffed the audits. I did not hear any evidence that either Glassman, the first audit engagement partner, or Messina, his successor, lacked the skill sets required to first audit a partnership operating through a nominee company, and then a publicly-listed company. It is unquestioned, as well, that Glassman had a wealth of experience with aggressive entrepreneurial managers such as Gottlieb and Drabinsky.

[129] It is also apparent that for the first years of the audit, from 1989 to 1995, Deloitte deployed senior staff and senior managers up to the position of audit engagement partner and LCSP, who were familiar with MyGar and Livent.[^93]

[130] As the audit engagement partner for the first five years of the engagement, Glassman was responsible for all aspects of the audit. He was obliged to, among other things, participate in a supervisory role in the audit planning, respond to questions from the staff while the audit was being conducted in the field and ultimately review the finished product for conformity with the audit plan before signing the audit opinion. He had the same senior managers working the engagement during his tenure: first Ron Cutway and then Maria Messina. Furthermore, there was some measure of continuity with the senior and field staff accountants during this period.

[131] Messina succeeded Glassman as the engagement partner in 1994 and continued in that capacity through the end of the 1995 audit. Because Livent was her first posting as an engagement partner, I was told that Glassman stayed more involved than he might otherwise have done in the first year of her appointment. In addition, her support staff was comprised of many of the same senior and junior accountants. Similarly, Peter Chant and Bob Wardell, two senior partners working out of the National Office, remained in the picture as Advisory or Quality Assurance Partners.

[132] In the final analysis, I am not persuaded that in the period to the end of 1995 the Deloitte staffing complement handling the audits was anything but reasonably competent. I am also satisfied that Deloitte would have been able to discharge the obligations of knowing and understanding the operation of the client as mandated by s. 5140, summarized above, with the teams that had been assigned to the audits in the years up to 1995. To foreshadow what is to come, I am satisfied that Deloitte did have issues in this regard in the two years thereafter, even though certain senior partners working out of the National Office remained involved in the audit to some extent.

b. The 1996 Audit

i. Backdrop

[133] 1996 was something of a watershed year for Livent and, as a consequence, Deloitte. It was a company that was seemingly in the limelight all the time, in part because of the nature of its core business, its flamboyant and headline-seeking CEO, Drabinsky, and because of all the attention it was getting in the popular press through articles in business media, investment analysts’ reports, The Financial Post, and Forbes magazine. Because of the nature of its business, it incurred significant upfront costs, irrespective of the success of the multiple productions that were then operating or under development. Furthermore, Livent had invested heavily in theatre and other real estate in New York, Chicago and Vancouver, in addition to the Pantages development in Toronto, all of which had to be financed.

[134] As a consequence, Livent was always casting a covetous eye to the capital markets, seeking to raise money either by way of debenture offerings or through public or private placements of its common stock. In 1996 alone, it raised in excess of $96 million, with an increase in liabilities, net of production trade accounts, of almost $70 million from 1995.[^94] Revenues from productions were not keeping pace with the demands of the operation and it became apparent that Livent was going to have to look away from its core business to fund its debt burden, at the very least. Indeed, in 1996 Livent took an $18.5 million write-off in respect of the Sunset Boulevard production, which was by no means insignificant. In the meantime, and perhaps unexpectedly, Livent convinced Messina to leave the Deloitte partnership and join the Company as VP, Finance in May 1996, where she assumed the additional role of CFO in November.

[135] As Deloitte started planning for the year-end 1996 audit, it was faced with the unenviable task of having to re-staff its audit team, while in the meantime maintaining some level of continuity to ensure transference of client knowledge and information. Deloitte thought that this had been accomplished by appointing John Cressatti as the day-to-day Engagement Partner, with support from Bob Wardell as the Advisory Partner and Glassman as the LCSP. Cressatti, who was a relatively new audit partner, had no experience with Livent or, indeed, with the Drabinskys and Gottliebs of this world, even though in 1994 he had done a review at Messina’s request of the capital accounts for the Pantages development from a real estate perspective only. And Glassman’s evidence was that he had minimal involvement with the client in 1996 and was rarely called upon, if ever, to speak with either Drabinsky or Gottlieb. That said, and for what it is worth, the senior manager, Christopher Craib, and the other senior staff were carryovers from the time when Messina was last Engagement Partner.

[136] There is no doubt that Deloitte assessed the engagement risk for the 1996 audit to be “greater than normal”, which was a Firm euphemism for “high risk”. When preparing the 1996 audit plan in which the overall assessment of the engagement risk was defined, the Deloitte senior staff and, presumably, the partners considered the following criteria:

1. The Company faced internal and external business and industry risks.

2. The Company had entered into a number of material and unique revenue-generating transactions, which created reporting issues.

3. The Company was publicly-traded in both Canada and the U.S. and attracted a high level of scrutiny and public observation.

4. Management of the Company was sensitive to reported net earnings levels, and was aggressive in arriving at its bottom line.

5. The valuation of preproduction costs was subject to management estimation and financial projections. In addition, resultant amortization and/or write-offs of PPC were known to have a significant impact on net earnings.[^95]

[137] While not specifically identified as an engagement risk for 1996, previous audit planning memos underscored the fact that senior management (Gottlieb and Drabinsky) was very demanding and expected timely, high-quality service at relatively low cost. It was previously understood that the pressures on the audit partners were and would be significant. Deloitte recognized that its tax group in particular might be able to provide additional services to Livent, although there was a strained relationship in that area, which had to be safeguarded in some fashion.[^96] Whether this inherent conflict between the Firm’s professional obligations, on the one hand, and its attempts to earn additional fees and satisfy the demands of its client, on the other, drove the audit agenda was never directly addressed in evidence, but sometimes appeared to be the elephant in the room.

[138] I had some difficulty reconciling certain other matters that made their way into the 1996 Audit Planning Memo. On the one hand, there was a clear mandate that the level of professional skepticism had to be increased on all fronts, which had to be and was supposedly communicated to all staff. In addition, it was anticipated that there would be more than normal Engagement Partner involvement, if not the utilization of two audit partners to ensure compliance with the audit plan, which suggests that there were concerns that had to be dealt with at the experienced-partner level only.

[139] What remained something of mystery to me, however, and one which was not readily explained by Deloitte, was the fact that the planning materiality level for 1996 was set at $1,670,000, an increase of roughly 30% from the previous year. This meant that, by definition, less drilling down would be undertaken by the audit staff even though there were some new and looming issues, as the planning memo suggested.

[140] I have reviewed the areas of alleged GAAS failure for 1996. I have concluded that Deloitte failed to meet its standard of care in the way it dealt with PPC, the Musicians’ Pension Surplus Receivable and the Revenue Transactions. Notwithstanding the detail to which Livent’s counsel went in marshalling the evidence and arguing its case, the plaintiff has not persuaded me that the other areas of concern, including Ticketmaster Exclusivity, Accounts Payable testing and Westsun Inducement Fee revenue, demonstrate on a balance of probabilities that Deloitte did not conduct the audit in accordance with GAAS. I now propose to canvass the three items listed above which occupied much of the trial and remain to be considered.

ii. PPC

[141] PPC was the first area of continuing if not growing concern for Deloitte and Livent’s Audit Committee. In May 1996, Bob Wardell was asked by Gottlieb on behalf of the Audit Committee to provide an overview of the appropriateness of the valuation of unamortized PPC, which stood at $55.5 million at year-end 1995. Wardell co-authored a letter to the Audit Committee in which he and his colleagues represented to the Committee that because of the “uncertainty inherent in projecting future revenues to be derived from individual productions”, Deloitte undertook a “focused audit approach” that would better enable them to ensure that the net recoverable amount and the actual amortization taken were properly computed in accordance with the new income forecasting policy put into place in early 1996, retroactive to 1995.[^97]

[142] He then went on to describe in detail the steps that Deloitte had taken during the 1995 audit, which permitted Wardell to conclude that Deloitte was satisfied that “unamortized preproduction costs and the amortization calculations were adequately documented and properly computed and that the financial statement presentation and disclosure was appropriate”.[^98]

[143] Leaving aside from this discussion whether or not Deloitte actually undertook the 1995 audit in the manner set forth in the Wardell/Deloitte memo to the Audit Committee, and, indeed, whether Wardell himself was aware of the enormity of the impact of the retroactive application of the new policy, there is no doubt that PPC and all aspects of PPC should have been front and center in the Deloitte collective mindset when it came to the completion of the 1996 audit.

[144] This proposition is further underscored by the nature of the tailored PPC audit plan that Deloitte designed as part of its overall audit. First, in one of its many pre-audit memos, we find the following observation:

The Company’s accounting policy for the deferral and amortization of preproduction costs is subject to estimates involved in predicting the potential success of individual shows. Although the Company’s experience in this area is growing significantly it remains an area of considerable subjective estimation in which differing results could materially alter reported earnings.[^99]

[145] Leaving aside for the moment my cynical view that Deloitte seems to have spent as much time preparing planning memos as it did conducting the audits, the tri-partite plan the Firm developed in respect of PPC included the following steps:

1. Test additions for the year to supporting documentation by obtaining the preproduction continuity by show …;

2. Test the amortization of the preproduction costs for reasonability;

3. Test the carrying value of the preproduction costs by testing the show forecasts, for selected shows, on a show by show basis.[^100]

[146] Critical to every aspect of this analysis was the fact that Deloitte undertook to “[o]btain operating projections for each production” and to “[c]ompare projected results with historical results where data available”.[^101]

[147] I do not intend to analyze in these reasons the detailed position of the parties found in either the evidence of Messrs. Froese or Regan or in arguments of counsel.[^102] If I understood the evidence in this very complicated area correctly, Deloitte selected Show Boat I, II, and III for testing. While I understood these shows were “big ticket” productions in 1996, it resulted in Deloitte not reviewing projections for Ragtime, Joseph or Phantom tour, which collectively represented $29.9 million or 30.6% of the $77 million of unamortized preproduction costs on Livent’s books at year-end. Hence, notwithstanding the Audit Plan, Deloitte arguably did not “obtain operating projections for each production”, as promised.

[148] It would also appear that Deloitte did not “compare projected results with historical results” for any production other than Show Boat II, which was done for the first three quarters of 1996 only. Furthermore, there is no record that the audit team compared budgeted amortization to actual amortization for the year even though it was aware that the productions universally performed poorly that year. Deloitte was aware that after amortization of PPC, the Livent shows lost, in the aggregate, $22.9 million, while they were projected to earn a net income of $20.6 million, a variance or swing of 218%. Indeed, while isolated instances of this kind of analysis were performed by the audit manager, Craib, it does not appear that others at Deloitte, including Cressatti (who was ultimately responsible) asked for, received and reviewed the 1996 budgets. The startling effects of this “oversight” are seen in the tables contained in Exhibit 33, which are self- explanatory:[^103]

Performance Revenue - 1996

Budget

Actual

Variance

Joseph Tour

(RTA, para. 199)

48,780,506

36,774,182

(12,006,324)

(25)

Show Boat 1 Tour

(RTA, para. 253)

48,949,595

40,582,104

(8,097,491)

(16)

Show Boat 2

(RTA, para. 264)

54,661,539

47,043,511

(7,618,028)

(14)

Show Boat 3

(RTA, para. 288)

51,698,250

45,950,839

(5,747,411)

(11)

MOTN Tour

(RTA, para. 99)

33,881,200

22,356,065

(11,525,135)

(34)

Income (Loss) before amortization of PPC (“Operating Profit”) – 1996

Budget

Actual

Variance

Joseph Tour

(RTA, para. 200)

10,166,644

7,022,203

(3,144,441)

(31)

Show Boat 1 Tour

(RTA, para. 255)

9,071,651

6,816,658

(2,254,993)

(25)

Show Boat 2

(RTA, para. 263)

4,108,157

(373,887)

(4,482,044)

(109)

Show Boat 3

(RTA, para. 287)

12,342,783

6,770,703

(5,572,080)

(45)

MOTN Tour

(RTA, para. 99)

6,562,522

4,494,442

(2,068,080)

(31)

Profit (loss) after Amortization of Touring PPC – 1996

Budget

Actual

Variance

Joseph Boston

(RTA, para. 203)

2,542,427

(3,948,448)

(6,490,875)

(255)

Show Boat 1 Tour

(RTA, para. 257)

4,153,263

(132,586)

(4,285,849)

(103)

Show Boat 2

No tour in ‘96

Show Boat 3

No tour in ‘96

MOTN Tour

(RTA, para. 99)

3,461,930

(436,823)

(3,898,753)

(113)

Net Profit (loss) – 1996

Budget

Actual

Variance

Joseph Tour

(RTA, para. 201)

4,529,144

(1,095,515)

(5,624,659)

(124)

Show Boat 1 Tour

(RTA, para. 257)

4,153,263

(132,586)

(4,285,849)

(103)

Show Boat 2

(RTA, para. 265)

3,086,747

(1,395,297)

(4,482,044)

(145)

Show Boat 3

(RTA, para. 290 )

7,642,657

4,364,663

(3,277,994)

(43)

MOTN Tour

(RTA, para. 99)

381,163

(436,823)

(817,896)

(214)

[149] Notwithstanding the second portion of the three-pronged test that Deloitte undertook to perform, namely a determination of the reasonableness of the amortization taken in the year, which I understood required a review of actual results to budgeted results, Mr. Cressatti steadfastly indicated to me throughout his evidence that such a review was satisfied simply by considering the end carrying value of the PPC by production. In other words, Mr. Cressatti was of the view that a review of the projections of revenues into the future by show, based on the estimates of management, without more, was sufficient to vouchsafe the numbers.

[150] First, in my view, this type of analysis thrust Deloitte into the realm of “audit by conversation” since it relied on and obtained by way of audit evidence the representations of management as to potential revenue for any one show. Second, they simply neglected to test these estimates for accuracy by failing to look long and hard at the recently experienced results, which, as the above tables suggest, had to cast doubt on the accuracy, if not the veracity, of what they were being told.

[151] What is a tad ironic, and what foreshadows some of the problems that became apparent in 1997, are the comments found in the post-audit Points Forward Memo, which is a memo to the Deloitte staff assigned to conduct future audits. Tina Patel, the senior auditor assigned to the team, made the following observation in respect of preproduction costs:

The selection of shows for which the performance forecasts are to be done should be made from interim reporting schedules. The forecasts should be made available preferably at the beginning of the audit.

The shows to keep a close eye on for future is Show Boat#1,2,3, Ragtime and Phantom tour. We should determine if the clients [sic] forecasting is reasonable by looking at the past forecasts vs. actual results[.] [W]e have the 1997 forecast for all three by city and in 1997 we will get the operating statements for each tour by city.[^104]

[152] Again, as best as I understand the Patel memo, it would seem that she and Deloitte were putting off until 1997 that which they had agreed to undertake in 1996, if the audit plans and the memos to the Audit Committee were to govern. That failure leaves me shaking my head. Even accepting, as Froese suggested,[^105] that the auditor should defer to management’s judgment when that judgment is within a reasonable range, Deloitte’s approach to the 1996 PPC audit cannot be said to have been in accordance with GAAS by any measure.

[153] Finally, the evidence indicates that Deloitte did not insist that management take a reserve for PPC in 1996 even though one was taken in each of 1994 ($2 million) and 1995 ($5.275 million) when the total capitalized PPC was significantly less than what it was in 1996. In fact, as I recollect this was not even a topic of discussion at Deloitte, notwithstanding the fact that Livent’s PPC issues should have given rise to a high degree of professional skepticism.

[154] In the final analysis, during the re-audit, an $11 million charge was taken against 1996 Net Income in respect of PPC not sufficiently amortized in the year. This amount is in addition to the $3.1 million that was improperly recorded or moved from account to account between various productions. The number in absolute and relative terms was beyond material. What should have been done along the way is another matter.

iii. Musicians’ Pension Surplus Receivables

[155] For the 1995 audit, Deloitte selected two pension surplus receivables for testing: those associated with the Kiss of the Spider Woman tour of New York and Show Boat New York. The audit of these receivables was conducted by Tina Patel and overseen by Messina, the audit engagement partner.

[156] Some explanation of the nature of these receivables is required. Livent had to use musicians from the New York Local 802 of the American Federation of Musicians union (“Local 802”) for performances in New York theatres. Under New York law, the theatres were required to deduct 4.5% from box office receipts and remit 23% of that amount to Local 802 on account of the musicians’ pension entitlement.

[157] Livent’s position was that Local 802 was entitled to less under the collective agreement than it was receiving by way of deductions from box office receipts, resulting in an overpayment that Livent was entitled to recover from the union and record in its books as a receivable.

[158] It turns out that Local 802 never acknowledged the alleged liability to Livent. Instead, it disputed the claim and ultimately prevailed. The receivables were written off on the re-audit.

[159] At the time of the 1995 audit, however, Deloitte did not confirm the receivables with the union and therefore did not find out that they were disputed. Instead, Deloitte accepted management’s representation that the receivables could be recovered from the union and that the receivables could be carried forward to off-set payments that Livent would have to make to the union from future shows in Chicago.

[160] Ms. Patel dutifully made a note of this explanation, and thereupon matched the payments to the accounts of the theatre at which the “receivable” was originally generated and passed on the receivables as appropriately tested. Deloitte accepted this explanation as reasonable for the 1995 audit because the Actors Equity Union had apparently agreed to a similar arrangement in the past. I do not agree with the plaintiff’s contention that the audit work undertaken by Ms. Patel for year-end 1995 did not accord with GAAS. I prefer the evidence and argument put forward by the defendants for that year. Given that the amounts in issue and the explanations for how they were being dealt with were reasonable, Deloitte was entitled to rely on management-prepared schedules and information and was not required to confirm those representations with the union.

[161] Patel tested the same receivables during the 1996 audit. Both Kiss and Show Boat had toured during the previous year. If Livent’s representation that the amount of the receivable would be set-off against future payments to the union was accurate, then one would have expected the amounts of the receivables to have declined. Instead, the receivable associated with Kiss remained the same, while that associated with Show Boat actually increased.

[162] This was a red flag and should have been recognized as such, especially considering that the audit risk for the 1996 audit was set at “high”. Unfortunately, it appears that Ms. Patel not only failed to raise her own level of professional skepticism, but also failed to even audit by conversation. She copied, verbatim, the notations she made during the 1995 audit to the effect that the receivables would be carried to Chicago. There was no apparent regard for the unexplained increase in the amount of the receivable, nor for the plainly contradictory notation made by Livent at the bottom of the same page on which Ms. Patel copied her note: “Surplus to be applied against future New York Productions”.[^106] When these work papers were put to Cressatti in cross-examination, he indicated that further inquiries should have been made to drill down to the bottom of the alleged receivable.[^107] Indeed, after some waffling under cross-examination, even Froese grudgingly acknowledged that the work done by Patel did not conform to GAAS.[^108]

iv. Revenue Transactions

[163] To but repeat what was set out above, as the fortunes of its core business headed south at the end of 1995 and into 1996, Livent entered into multiple “material and unique revenue generating transactions” which Deloitte observed motivated management to select reporting methods that were “less favourable than potential alternatives”, whatever that term meant.[^109] These transactions throughout the course of the trial were referred to as the “Dewlim”, “Pace-Show Boat”, “Pace-Ragtime”, and the “Ticketmaster Exclusivity” agreements. There were two other agreements which covered the naming rights and exclusive sponsorship rights for the yet-to-be-built theatres in New York and Chicago (“the Ford Agreements”), which also became the subject matter of much debate within the Firm and Deloitte U.S.

[164] The details of these agreements appear multiple times throughout the course of the evidence and in each of the expert reports. Indeed, to make matters more manageable and understandable, counsel provided me with an agreed statement of facts, Exhibit 29, setting out the elements of each of the transactions. Central to each of these agreements, save for the Ford Agreements, is the fact that Deloitte was not given the full story and, in each case, there were companion agreements, written or oral, which modified the written agreements provided to Deloitte. However, having regard to my conclusion in respect of whether or not Deloitte audited these transactions in accordance with GAAS, at least to the fall of 1997, I do not find it necessary to précis Exhibit 29.

[165] The starting point for any analysis of the Revenue Transactions is the Audit Planning Memos for 1996, which included a financial statement presentation memo tailored to the reporting of theater naming and touring production rights.[^110] As previously indicated, the Deloitte audit team was well aware of the issues associated with the then-identified Revenue Transactions. Like the PPC issues, these transactions were highlighted for specific review and it was determined that “focused substantial tests” would be undertaken. This analysis anticipated, further, that the transactions would be reviewed “by senior audit personnel” with “direct discussion and analysis with senior client management”.

[166] In addition, it was anticipated that the Revenue Transactions would receive special treatment in the financial statements as follows:

• all items will be identified in SCFP [Statement of Consolidated Financial Position] as non cash transactions

• disclosure of commitment under agreements, especially the touring productions

• separate line item disclosure of non-production revenue sources with an accounting policy

• long-term receivable note will indicate all details of transactions, and amounts that have been credited to income in the current period, (pursuant to 1994/5 disclosure).[^111]

[167] Interestingly enough, and for reasons that were never explained, I was told that none of these four planned disclosures were separately identified as part of the 1996 Original Statements.

[168] An important piece of evidence is the chronology of events prepared by Bob Wardell in late July 1997. It was prepared in anticipation of a meeting between Martin Calpin, Deloitte’s National Risk Management Partner, and Gottlieb, who was continually threatening to drop Deloitte as Livent’s auditors.[^112] The Wardell Chronology, as the document became known during the trial, detailed the events leading up to the inclusion of revenue generated from these transactions in accordance with Canadian GAAP, in March, and U.S. GAAP, in July, but only after a significant amount of partner time was devoted to the issue. Some of the items worthy of highlighting from the Wardell Chronology are as follows:

• In late January 1997, Messina was asked by Wardell to assemble an information package containing the relevant agreements and schedules pertaining to the Dewlim, Pace, and Ford Agreements in preparation for the audit. The Ticketmaster Exclusivity Agreement was not given “special” consideration for GAAP purposes as it was considered to be a straightforward agreement, much like other exclusive rights deals, for which the total up-front fee received from Ticketmaster was included in income in 1996.

• Messina was not able to provide signed copies of all the agreements in a timely fashion, which did not seem to faze Wardell.

• He and Cressatti met with Messina, Gottlieb and Topol, who negotiated the Pace agreements, on several occasions before the statements were finalized for presentation to the Audit Committee on the 7th of March.

• After much discussion locally, Wardell agreed that the following amounts would be included in income from a Canadian GAAP perspective for 1996:

(a) $2,048,250 - Ticketmaster Exclusivity Agreement;

(b) $6,231,549 - Pace Show Boat agreement;

(c) $4,231,015 - Dewlim Agreement;

(d) $5,965,016 - Pace Ragtime agreement;

(e) $6,251,925 - Ford Right of First Negotiation;

(f) $7,024,175 - Ford Naming Agreement;

• Gottlieb was not pleased that Deloitte was questioning Livent management on the agreements and felt that Deloitte U.S. was dragging its feet in agreeing with the inclusions of the same amounts for U.S. GAAP purposes. He threatened to pull the account if Deloitte did not accept Livent’s accounting treatment of the transactions.

• After consultation with Peter Chant, the Canadian National Accounting and Auditing Technical Partner, Wardell reported to the Audit Committee that he was prepared to accept the income numbers set out above and was confident that Deloitte U.S. would follow suit shortly.

• As matters progressed through the end of March, Deloitte U.S. was still not prepared to accede to the demands of Livent and remained firm that some or all of the income to be generated under certain of the Revenue Transactions had to be deferred to other years. This position, again, did not sit well with Gottlieb.

• At the end of March, Wardell met with two other senior partners of Deloitte, Bruce Richmond and Paul Cobb. The latter was responsible for the Dundee Bancorp audit. Wardell “was concerned not only with the impact these events were having with respect to our relationships with Livent, an important public client, but also the possible fallout to Dundee Bancorp given Myron’s relationship with Ned Goodman and his position as Chairman of Dundee’s audit committee”.[^113]

• Multiple conversations were held among Chant and Wardell, on the one hand, and various of their U.S. partners, on the other, in an attempt to persuade the latter group to accept the proposed accounting from a U.S. GAAP perspective. Further information was solicited from Livent’s senior management which was used to bolster what was now the Wardell-Chant position in an effort to have Deloitte U.S sign off on the transactions. To this end, Chant prepared a detailed memo reviewing the transactions, in which he provided an opinion justifying the inclusion of income in the 1996 Original Statements.

• The U.S. Partners were unmoved by the arguments. In June, Rod Barr, a senior Canadian partner in the National Office and a specialist on SEC matters, was asked by his American counterparts to weigh in on the argument. He reviewed the transactions but remained adamant that the Canadian position was flawed and “would NOT withstand the scrutiny of a professional skeptical challenge”.[^114] In this prophetic memo, he raised four areas of concern, which ultimately formed the basis of the plaintiff’s criticism of Deloitte in respect of the transactions:

(a) Was Deloitte certain that there were no side deals “or other relationships among the counterparties” that would alter the nature of the agreements?

(b) Why were the agreements silent on refundability?

(c) What analysis had been undertaken to ensure that the counterparties had the ability to meet their commitments under the agreements?

(d) What audit procedures were actually undertaken to check on the legitimacy of the agreements, since the U.S. partners were under the impression that much of the work comprised an audit by conversation, only?

• Wardell was not persuaded that the complaints and warnings articulated by Barr were warranted. While he was more inclined to accept that the deals reached were obtained because of the “level of sophistication, business acumen and negotiating skills of Messrs. Drabinsky [and] Gottlieb”, a position which he believed was lost on his U.S. partners, he was in large measure, relying on the “written and verbal representations from Livent’s senior in-house counsel and all senior executives”, including his former partner Messina, that there were no undisclosed agreements or amendments. He went on to observe: “If we were not prepared to accept such representations, it seems to me we should resign as auditors as we effectively would be questioning the fundamental integrity of our client”.[^115]

• Gottlieb insisted on a face-to-face meeting with partners from the US firm in New York. On July 10 a meeting was held with four senior partners from Deloitte US, three partners from the Firm, including Chant, Wardell and Barkin, and Drabinsky, Gottlieb, Messina, Topol and Eckstein on the Livent side.

• After a lengthy meeting in which the issues were reviewed yet again, the US partners met separately with Peter Chant and determined that they were prepared to accept immediate revenue recognition in respect of Pace-Show Boat and the Ford agreements only. They were not prepared to accept revenue recognition for Pace-Ragtime. They were only prepared to accept revenue recognition of the Dewlim agreement after certain pre-conditions were satisfied.

• In the final analysis, Deloitte US was only prepared to accept $16 million of the originally requested for $26 million.

• Finally, Rod Barr was asked to perform an independent review of the audit files to ensure compliance with the Deloitte manual, which he did and which was signed off on as at July 15, 1997.

[169] As previously suggested, the Wardell Chronology was prepared as an aide mémoire for Martin Calpin in preparation for a meeting that was scheduled to take place with Gottlieb in late July, during which Gottlieb wanted to discuss “relationship and client services issues”. Gottlieb clearly believed that the best defence was a good offence and, as I assess the evidence, bullied the Deloitte partners to bend to his positions, with the added leverage of his connection to Dundee Bancorp and its CEO, Ned Goodman, which he threw in for good measure.

v. Conclusion

[170] I have concluded, and not without some misgivings, that Deloitte, as of middle of July, could not be faulted for the work it did in respect of the Revenue Transactions and the conclusions it reached. A significant amount of partner and staff time on both sides of the border was spent reviewing these transactions. That said, the criticisms leveled by Regan in this action, which to some extent parallel the concerns expressed by Barr in June 1997, are not without merit. However, I am not persuaded that, had Deloitte undertaken any of the audit steps suggested by seeking further confirmation from the counterparties to the Dewlim and Pace Agreements, such would have revealed the frauds. The simple fact is that Deloitte was lied to and misled about the nature of the transactions up and down the management line, which included, to a greater or lesser extent, prevarications from in-house counsel, executives other than Gottlieb, and Messina, a former partner. When attempts were made to vouchsafe the credit of Dewlim, for example, Deloitte was misled yet again by a client, if not by the silence of Andy Sarlos, a Livent board member and the person who initially negotiated the deal with Gottlieb. I have no reason to conclude that, had Deloitte undertaken the investigatory steps beyond the audit standards suggested by Regan, the results at that moment in time would have yielded more or different information.

[171] While I have concluded that Deloitte did not conduct an audit in accordance with GAAS in respect of the PPC and Musicians’ Pension Surplus Receivable accounts, I am not satisfied that a confrontation with management over these accounts as deductions from revenue would similarly have revealed instances of fraud or other irregularities sufficient to close Livent down.

[172] First, even if Deloitte had concluded that the PPC, for example was overstated in 1996 and greater amortization had to be taken, I saw little, if anything, that would permit me to conclude the “amortization rolls” would have come to light. The PPC issues at this time did not focus on which accounts should have been written off, but rather on whether the new policy recently adopted was being complied with.

[173] Secondly, from what I learned about practice issues, when an auditor uncovers items or misstatements that, individually or collectively, would exceed materiality, rather than simply withholding a clean opinion, the issues are first discussed with management to see if some middle reporting ground can be achieved. In the instant case, and even though it was often “Gottlieb’s way or the highway”, I have no reason to conclude that, when push came to shove, Gottlieb as the pragmatist would not have yielded to the suggested write-offs rather than pull the plug on the enterprise. His hubris and the conceit of Drabinsky, and their collective view that their frauds would not be discovered, would have driven that agenda. Indeed, as will be discussed when reviewing the facts leading up to the sale to Ovitz and Furman in early 1998, Gottlieb and Drabinsky were prepared to take massive write-offs first before the deal was done and then in Q2, 1998. Those write-offs speak volumes in terms of the pragmatism of Drabinsky and Gottlieb, which, in my view, undercut Mr. Howard’s argument to the contrary. Hence, on balance I am not persuaded that the negligence had caused any compensable harm as of the signing of the opinion in 1997 for the 1996 Original Statements. I will return to the causation issue in Part II of these Reasons.

c. The 1997 Audit

i. The Pantages Air Rights Agreement and the Now-Infamous Put

[174] This Revenue Transaction that formed the subject matter of a letter of intent between Dundee Realty Corp. (“Dundee”) and Livent in May 1997 is, on many levels, the most critical of the transactions and the one that, in the final analysis, amounted to the Achilles heel of Deloitte’s defence. Accordingly, because of its importance to the Deloitte-Livent saga, I have devoted a considerable amount of space to the chronology of events in these Reasons.[^116]

[175] In May 1997, Dundee and Livent entered into a letter agreement by which Livent purported to transfer to Dundee, through a joint venture development company (“Newco”), the air rights existing above the Pantages Theater and the lands contiguous to the Pantages for purposes of the erection of a condominium-hotel tower and a new theater (collectively referred to as the “Air Rights”). The total consideration for the transfer of the Air Rights was $7.4 million. The letter of intent also contained a put in favor of Dundee, which allowed Dundee to exit the deal, among other reasons, if construction had not commenced by December 31, 1999 (“Put”). The transfer was memorialized in an unexecuted agreement dated December 10, 1997 (“Master Agreement”), which included, among other things, the details of the Put. Wardell was provided with a copy of the Master Agreement and was well aware of the intention of Livent to generate more income through another of the Revenue Transactions with which he was then dealing on other fronts.

[176] Wardell prepared another memo to file in early August 1997, which I find to be just as telling as his previously described Chronology. Some of the highlights are as follows:[^117]

(a) The proposed deal formed the subject matter of several meetings and discussions between Wardell and Chant, on the one hand, and Gottlieb, Messina and Eckstein, on the other, in late July and the first week of August.

(b) Deloitte objected to the inclusion of any amount of revenue in respect of the transfer in Q2 since it was of the view that the deal was but a contingent agreement. First, the agreement was still unexecuted. Secondly, from a GAAP point of view, Dundee was not paying upfront all or enough of the balance of the transfer price for the transaction to qualify as a sale. Thirdly and more importantly, the Master Agreement contained a Put, that effectively allowed Dundee to “avoid responsibility for the repayment [sic] of the balance of the $4.9 million that would ultimately be owed to Livent”.

(c) Additionally, and by no means least, Wardell believed the transaction raised valuation issues since the sale could not be recorded at a zero cost base as Livent apparently wanted having regard to the almost $21 million of capitalized costs associated with the investigation and development of the site to that date.

(d) Finally, Wardell alerted Gottlieb to certain U.S. GAAP issues that would have to be attended to, like the others that had just been “resolved” on the other Revenue Transactions, because the American regime in respect of the sale of density rights was different than that in Canada.

(e) Messina informed Wardell on August 6th, just before he went on vacation, that “Myron was … pushing to have a significant gain (i.e. $6 million) on the Pantages transaction reflected in Livent’s second quarter results and to have no disclosure relative to such inclusion”,[^118] meaning to include the amount as revenue from operations and not as a separate line item.

[177] I hasten to observe that Wardell was aware at the time that he prepared the memo that Livent proposed to access the capital markets, yet again, in the Fall and needed strong Q2 results.

[178] Wardell concluded the Air Rights Memo with the following paragraph, which I quote verbatim:

On Wednesday, August 6, 1997, I called Myron to inform him that I was extremely concerned that he would even consider this course of action in that:

(1) the transaction clearly was not a second quarter transaction.

(2) I was skeptical as to the quantum of the so-called gain; and

(3) non-disclosure was not acceptable under GAAP.

I advised him that if the second quarter results were to include a material gain on the Pantages transaction, we would not be in a position to provide any comfort to any regulators, underwriters or audit committee members as to the interim financial statement’s conformity with GAAP.

[179] Notwithstanding the strong wording of Wardell’s warning, Gottlieb nevertheless went to the Audit Committee and tabled the draft audited consolidated financial statements for the quarter and six months ending June 30, 1997, which included a purported $6 million gain on the sale of the Air Rights, albeit showing it as a separate line item, but as part of theatre revenue.

[180] Interestingly, the minutes of the Audit Committee meeting do not show that Gottlieb, Eckstein or, indeed, Messina advised the Committee about the strong position previously taken by Deloitte in opposition to the inclusion of any amount in Q2 for the sale of the Air Rights.[^119]

[181] The statements were approved by the Committee as tabled and a press release which showed a modest increase in Q2 income from the year before was issued without a word of explanation or delineation. I note that Livent would have shown an operating loss for that period but for the inclusion of the gain on the Air Rights sale.

[182] Wardell heard about the Air Rights accounting from Messina shortly after the Audit Committee meeting and his return from vacation. He and Chant were understandably upset and one or the other of them advised Gottlieb that Deloitte was going to exercise its statutory right as an auditor to insist that an Audit Committee meeting be convened, at which time Deloitte intended to tell the Committee that the Firm had concluded that the “second quarter results of operations [were] materially misstated as a result of the second quarter accounting treatment of the Pantages Place Project”.[^120]

[183] In the meantime, and before the meeting could be convened, Gottlieb purported to pre-empt or eliminate certain of Deloitte’s concerns by having Livent’s lawyer, Rod Seyffert of Smith Lyons, redraft the Master Agreement by, inter alia, specifically deleting the Put or at least any reference to the Put in that Agreement. What went undisclosed until the following April was the fact that the Put had instead been inserted, presumably by Seyffert, into a side agreement that was kept secret from Deloitte (“First Put Side Agreement”). The net effect was that in reality nothing had changed from a GAAP point of view and the transfer was at, best, the subject matter of a contingent agreement. In other words, no revenue could or should have been recognized in income, regardless of the quarter, so long as the Put remained outstanding.

[184] The first of three Audit Committee meetings was held on August 26th. Chant, Wardell, and a third Deloitte partner and Vice Chairman of the Firm, Doug Barrington, were in attendance, together with the usual suspects from Livent’s top management. At that meeting, Deloitte’s position and concerns about the inclusion of the sale revenue in the Q2 results were reiterated for the other reasons described above, even though the Put had been purportedly removed from the Master Agreement as at the actual closing date for the transfer, namely August 15th.

[185] The discussions accelerated and intensified over the next several days, with Deloitte remaining firm in its resolve to oppose the inclusion of any revenue from the Air Rights transaction in Q2 income. The Firm maintained this position even though: (a) Dundee provided a letter, which turned out to be misleading, confirming that the Put “was removed from the master Agreement at the request of Livent Inc.” and that Dundee was committed to closing the deal (“Dundee Acknowledgement”);[^121] and (b) Seyffert delivered multiple opinions, which turned out to be misleading as well, stating that there was a firm deal for the sale of the Air Rights, effective as of June 30th (“Seyffert Opinions”).[^122] Both these letters were delivered to Deloitte at the second meeting with the Audit Committee during the morning of the 27th, at which Messrs. Barrington, Chant and Wardell were again in attendance.

[186] As late as August 28th, Deloitte, in a further letter to Gottlieb, again maintained its position that the Q2 statements were still materially misleading, notwithstanding receipt of the Dundee Acknowledgement and the Seyffert Opinions. This bit of brinksmanship caused Gottlieb to shop for other opinions from KPMG and his now go-to accounting guru, Professor Archibald, both of whom supported the Livent position that the transaction was, arguably, properly reportable in Q2. Deloitte came to the August 28th meeting again reiterating its position that the sale revenues could not be reported in Q2 because no tangible consideration had passed prior to June 30th, the transaction had not closed as of that date, and the appropriate GAAP guidelines would not permit revenue recognition.

[187] The matter appeared to come down to whether or not Deloitte would resign as auditors or whether or not some accommodation could or should be negotiated. Gottlieb and Eckstein were now content to let Deloitte resign since they felt that Livent would be able to obtain a satisfactory opinion elsewhere, presumably from KPMG. Others at the meeting, including Emerson and Goldfarb with support from Banks and Messina, felt that Livent would be adversely affected if Deloitte resigned prior to the proposed debt placement in the fall. Emerson included the following observation in his notes on the effects of a Deloitte resignation on, among other things, sponsors such as Ford, which seems to have captured the mood of the debate:

Other sponsors may have second thoughts about a relationship with Livent if there was a public dispute about the integrity of Livent’s accounting policies and accounting principles and the resignation of Livent’s auditors because of a reportable difference with Livent.[^123]

[188] In my opinion, what would have been of equal concern had Deloitte resigned over differences over accounting principles would have been the fact that Deloitte would have had to advise the regulators of this dispute, if not the successor auditors. This might very well have sounded the death knell to the proposed debenture offering.

[189] At the conclusion of the August 29 meeting, however, Deloitte and the Livent executives and audit committee members came to a resolution of the issue, which brought Deloitte back from the brink of having to “disassociate” itself from the Company. The evidence I heard suggests that the proposed solution, which had not been raised prior to the 29th, came from Peter Chant. The essence of the solution was embodied in a press release issued on September 2nd:

Livent Inc. announced today that in contemplation of a possible issuance of U.S. $100 million debt securities in the United States, it has adjusted its accounting treatment for non-theater real estate transactions in order to be consistent with US GAAP. This adjustment, which has no effect on prior years’ income, will result in the recognition of income before income taxes of $4.8 million ($0.17 per share) in the third quarter of 1997 rather than in the second quarter, as previously announced. The adjustment is in connection with the sale by the Company of air rights to a real estate developer pursuant to a binding contractual arrangement in place prior to the end of the second quarter.[^124]

[190] I make three observations about the September 2 Press Release:

(1) The draft press release, which I assume was first prepared by Livent, indicated initially that $6 million would be removed from second quarter results and not the $4.8 million that appeared in the actual Press Release.

(2) The Press Release “did not tell the whole story” and left the reader with the mistaken view that the decision was not driven by the articulated concerns of Deloitte, but by a U.S. GAAP issue that appeared to be a mere technicality. Implicit in the Press Release was the suggestion that recognizing the revenue in Q2 complied with Canadian GAAP, or that the decision was undertaken because of a change in Livent’s accounting policy.[^125]

(3) I wonder how Deloitte could countenance a press release that suggested there was a binding deal as at the end of Q2 when the deal was materially amended in August by, minimally, the dropping of the Put, especially given Deloitte’s strongly-worded objections in late August to treating the deal as a Q2 transaction, at all.

[191] While the evidence was anything but crystal clear on this point, the net effect of the backing out of the $4.8 million meant that $1.2 million referable to the Air Rights sale was left behind in Q2. This seemed to be done at the insistence of Gottlieb and without the prior concurrence of Deloitte. There was some debate among counsel, subsequent to oral argument, and at my request, which seemed to leave the rationale for the change in amount very much at issue. In any event, when the matter came to the Firm’s attention, it did not make it an issue.

[192] Wardell struck me as a no-nonsense fellow, which in retrospect did not sit well with Gottlieb even though he, Wardell, went to bat for Livent in the early days of the Revenue Transactions debates between the Firm and Deloitte U.S. However, Wardell took the position that even if the September 2nd Press Release did not tell the whole story, and Deloitte was aware of this, it was not obliged to rectify the situation in its capacity as auditor. What concerns me about this evidence is that it paints Deloitte perilously close to being negligent by omission, which has the same fatal results for an auditor as acts of commission. In my view, the line between an auditor responding to the will of management, as in this instance, and its obligations to the company and its shareholders has a tendency to become blurred.

[193] In the final analysis, I was not comfortable with the fact that Deloitte, for all intents and purposes, not only countenanced a misleading representation to the public on the eve of a public offering for which it was going to have to provide a comfort letter, but provided its initial inspiration. Ultimately, I believe Deloitte lost sight of the stated rationale for the deferral of the revenue from this transaction to Q3.

[194] But the issues surrounding the Revenue Transactions, and the Air Rights transaction in particular, did not die with the September 2nd Press Release. Indeed Gottlieb, as part of his “hurry-up” offence, summoned Barrington and Tom Cryer, the Deloitte chairman, to a meeting on September 19th to discuss the future of the Deloitte/Livent relationship.[^126] He took the position that Wardell had to be relieved of his duties as the “uber” Engagement Partner, let alone as the Review Partner, because he had compromised himself. Based on the notes of this meeting and correspondence in the days ramping up to the Air Rights closing from Seyffert in particular, it seems that Gottlieb was trying to blame Wardell for the Air Rights controversy by suggesting that the issue of the Put had been canvassed with him and his prior approval obtained in the early days of the first draft of the Master Agreement. Otherwise, Gottlieb was trying to suggest that Wardell made a significant error in advising Gottlieb that the U.S. GAAP issues on the other Revenue Transactions would be resolved to his satisfaction.

[195] During their meeting with Gottlieb, Cryer and Barrington repeatedly expressed the view that they believed Livent constantly pushed the envelope. They wanted Livent to adopt a more conservative approach to accounting issues. But they still agreed to make a change in the audit team rather than considering Gottlieb’s request as a “red flag” warranting a review of the entire relationship from Deloitte’s perspective, rather than from the client’s perspective. I am not sure the Livent-Dundee and Goodman-Gottlieb relationships were not forming part of the backdrop against which this decision was made.

[196] Whatever might have been Deloitte’s motivation to continue as auditor, I have concluded that it was too accommodating at this point and put itself in a most curious if not fatal position by changing the audit team, virtually from top to bottom. While Barrington and Chant assumed the role of joint Advisory Partners, with the appointment Tony Power as the LCSP, Cressatti was dropped from the roster as the Engagement Partner to make room for Claudio Russo, who had previously worked for Power. In fact, none of the support and field staff remained the same as there was a wholesale change on that front, as well, with not even one staff auditor kept in place for minimal continuity purposes. Putting the matter bluntly, but for whatever information could be gleaned from the Permanent File, a file that forms part of the work papers that moves from audit year to audit year, there was no one on the team who had any past connection to the client and had any sense of the history to which the audit team should have been alert.

[197] This problem is underscored by the error made by Deloitte in accepting the Air Rights revenue for inclusion in Q3 in any event, but minimally, in a manner which was inconsistent with the September 2nd Press Release. At the time that Chant sowed the seed for the aforesaid compromise, he was mistakenly of the view that the transaction could be recognized in Q3 under U.S. GAAP when, in fact, it could not.[^127] While this problem was brought to Power’s attention, which he communicated to Gottlieb, he went on to say:

It is, however, our opinion that the sale would qualify for gain recognition under Canadian generally accepted accounting principles, the basis on which Livent normally reports. We have received from management and reviewed the calculations with respect to the allocation of costs associated with the Pantages Place Project to the sale of density rights. We are satisfied that a fair allocation of costs has been made and it is appropriate to record a gain on the sale of the density rights in the amount of $4.8 million under Canadian generally accepted accounting principles.[^128]

[198] I agree with Mr. Regan’s conclusion that it was not open for Livent to recognize a gain on the sale of Air Rights in Q3 1997 when it had issued a press release that stated unequivocally that it was backing out the gain to accord with U.S. GAAP—and then did not adhere to the restrictions described by U.S. GAAP. In fact, Barrington ultimately agreed with this conclusion in his cross-examination where he said that “[i]f you adopted U.S. GAAP and it didn’t qualify, then it shouldn’t be in Q3”.[^129]

[199] The issue of lack of continuity and the companion notion of cumulative knowledge were next seen in the manner in which the new audit team accounted for the costs associated with the recording of the Air Rights net revenue when they signed off on the number in November. Without getting into the numbers per se, and where the inconsistencies actually lay, it became apparent in the Russo cross-examination that he was unaware of the earlier assessments of costs that had been done by prior audit teams or that was found in the 1997 budget. Indeed, when Russo consulted with one of the national office’s technical gurus and was told that the Air Rights transaction would not pass the “smell test” because “all of their income of late [was] from ancillary non-recurring items”,[^130] a comment that was reminiscent of the Barr analysis expressed the previous July, no warning bells were heard, if they were in fact sounded.

[200] Indeed, it is no wonder that Russo did not pick up on the nuances of the past activities and concerns of some of his partners since he, if not Power, was scrambling to catch up after being thrust on to the Livent file in late September. The Firm had to provide a comfort letter on the statements prepared by management to the end of Q2, and up to October 7th, all of which was prepared to accompany the Offering Memorandum released on October 10th in respect of the U.S. $125 million debenture underwriting.[^131] Logic suggests the work he and his team did thereafter could not have been sufficient to bring them up to speed on all the issues that were then outstanding.

ii. Conclusion—Q3—1997

[201] In my opinion, Deloitte should have remained firm in its resolve to sever its relationship with Livent at the end of August 1997 at the earliest, but no later than the end of Q3, or September 30th, at the latest. The red flags were certainly aflutter by that time. While the Firm, even with the change of audit teams, was clearly aware that Livent’s management was more than merely pushing the envelope from a GAAP perspective, it seemed to turn a blind eye to the warning signs, which I attribute to the fact that it was only too amenable to a line-up change, which it thought was the panacea. I shudder to think it was all about the $50,000 fee they received for the Review Engagement undertaken as a pre-cursor to the October Underwriting or the $95,000 fee charged in respect of the 1997 Audit.

[202] In my view, there was a complete break-down in the relationship when Gottlieb purposefully placed the Q2 statements before the Audit Committee in early August when he and the rest of his toadies knew that they contained information which Deloitte presaged amounted to material misstatements. To place the statements before the Committee in that form was bad enough. But not to tell the Audit Committee that Deloitte had warned Gottlieb, if not Messina, against this course of conduct, was inexcusable. This action was not simply one which could be negotiated away, particularly since Gottlieb prohibited Deloitte from attending Audit Committee meetings when the quarterly statements were tabled and reviewed. I would also venture to say that Gottlieb did not think Deloitte had the backbone to force the issue by insisting on their statutory right to require a meeting with the Audit Committee as such was an extreme measure not undertaken lightly by auditors.

[203] Furthermore, while Wardell, and no doubt Chant, were clearly upset by this turn of events when they first learned about the proposed statements in early August, I did not get the sense that they expressed their level of concern about Gottlieb’s integrity with Emerson and the only other remaining “independent” member, Goldfarb, during the three meetings at the end of August.

[204] Deloitte knew the management of both Dundee and Livent and would have understood that the original Air Rights letter agreement had been product of “intense business negotiations”.[^132] I therefore cannot understand why no one at Deloitte questioned either Seyffert or Michael Cooper, the president of Dundee Realty, about the fact that the Put was apparently “intentionally deleted”, if not to accommodate the revenue recognition issue. Surely, their collective professional skepticism should have been elevated at this point when they had reason to question the integrity of Gottlieb with or without knowledge of the other Revenue Transactions at the time!

[205] The situation, in my view, deteriorated even further when Deloitte agreed to the September 2nd Press Release, when it knew or ought to have known that it contained a misstatement in and of itself. And why Barrington did not realize that he was or might be being played when he was asked to remove Wardell and basically his entire audit team even for the Review Engagement leaves me wondering whether he occupied too exalted a position in the Deloitte ranks to remember what professional skepticism was all about.

[206] To make matters worse, Gottlieb soon sought to include the present value of a new revenue transaction in the Q3 results. In mid-September, Gottlieb entered into a handshake deal with AT&T for the naming rights of the Pantages, the payments in respect of which were to be spread out over 10 years. Power, who had not witnessed first-hand the 1996 Revenue Transaction debates, and had not debriefed Wardell, initially took the position that the transaction could not be recognized in Q3 because there was no signed agreement and the cash paid on signing would not reach 3% of the total payments.

[207] The ever irrepressible Gottlieb obtained another opinion from Seyffert in early November that the September oral negotiations between Livent and AT&T amounted to an enforceable agreement. Still faced with opposition from Deloitte, Gottlieb negotiated an amendment to the deal which by then—now in November—had AT&T increasing its down-payment from $300,000 to $1 million, which was still less than 10% of the total contract price, in an agreement that was dated “as of September 10th”. Finally, in support of this position, Gottlieb obtained an opinion from E&Y that the transaction “could” be recorded in Q3, without opining on the manner in which it should be recorded.

[208] Deloitte, with its back to the wall, in the most unusual of circumstances, obtained their own opinion from PwC, which was to the same effect as E&Y’s. When push came to shove, Deloitte modified its tough stance of the previous month and basically offered no opinion on the issue:

It continues to be our opinion, taking into account all aspects of this transaction, that the preferred treatment is to record the revenue in the Company’s fourth quarter results. Furthermore, it is our opinion that under U.S. generally accepted accounting principles, this revenue would not be recognized in the third quarter. If in the opinion of management and the Board it is appropriate to reflect the transaction in the Company’s third-quarter results, we will not object but would suggest that the appropriate disclosure for this transaction would be similar to that set out in the offering document with respect to similar transactions.[^133]

[209] Finally, although it takes me somewhat out of the Q3 time frame, I have more than modest difficulty accepting the accounting treatment of the Air Rights transaction in November, when Power and Russo signed off on the numbers without revisiting the operation of the U.S. GAAP strictures and the information that would have been available to them if continuity of audit team personnel had been maintained. This to me was but another example of Deloitte accommodating the needs of the client while casting professional skepticism, if not GAAS, aside.

iii. The Infamous Put, Part Deux

[210] The 1997 audit was beset with problems right from the get-go.[^134] First, it was staffed by new team members who, but for Chant, had little or no history with the client and senior management. Secondly, the team that was parachuted into the audit was still reeling from the quickly-undertaken Review Engagement. Thirdly, Livent had entered into five more Revenue Transactions which required renewed and increased attention to detail. Fourth, and by no means least, the issues surrounding PPC took on an added dimension before audit sign-off when Ovitz and Furman asked for about a 20% reduction in the capitalized PPC as a condition of their share purchase. I have concluded, with some mixed emotions or misgivings, with Power and Russo splitting its over-all supervision, and with Barrington acting as the field marshal from the rear, that the team was not up to the task.[^135]

[211] First, the 1997 Audit Plan (“Plan”) conveys the impression that the Team did not engage in much independent thought when drafting it. The Plan tracks the language of the 1996 Audit Plan in most material respects, but eliminates certain cautionary tasks or descriptions which would have been of benefit to an audit staff charged with the responsibility of auditing a “greater than normal” risk audit client that had more than a modest history of aggressive, if not questionable, accounting practices.[^136]

[212] Secondly, and before the audit was completed, Deloitte uncovered evidence that suggested that the Put they had been told had been “intentionally deleted” was alive and well and living in the Dundee copy of the Air Rights sale closing book. Because this part of the story is stranger than fiction, I will endeavour to set it out in detail.

iv. The Put Uncovered

[213] On or about April 2nd, Bob Savaria, the Deloitte Engagement Partner on the Dundee audit, was told by Cooper that Dundee Realty took the position that the Put was still operative and, hence, Dundee Realty did not have to consolidate its statements with those of the Pantages Newco. As a result of this conversation, Savaria asked Cressatti to attend at the Dundee offices to review the closing book, at which time he retrieved a copy of the Put that was then memorialized in a separate lawyer-crafted three page agreement.[^137] Savaria communicated the existence of the Put to Wardell, who then brought it to the attention of Chant. Chant advised Russo who then told Power, after which all hell broke loose. Power called a reluctant Savaria and demanded to be sent a copy of the document just recovered, which was then faxed to him. Power was concerned that this discovery had very serious implications as it basically contradicted what Deloitte had been told the previous August. In fact, Power conceded under cross-examination that it was possible that Gottlieb had “lied” to Deloitte back in August—a fact which he downplayed in the course of his evidence.[^138]

[214] A meeting of senior partners was convened on the 3rd at the Deloitte offices. In attendance were Chant, Barrington, Power, Russo, Calpin, Bruce Richmond (Senior Partner in charge of Client Relations), Paul Cobb (LCSP-Dundee), internal counsel and external counsel, J.L. McDougall.[^139] There was conflicting evidence and a modest dispute among counsel as to whether or not Savaria was in attendance at the meeting. All the partners who testified before me acknowledged, however, that their collective professional skepticism would have been at the highest level.

[215] Chant, who did not testify at the trial, but whose evidence on discovery was excerpted and filed as an exhibit, does not recall whether or not a copy of the Put had been tabled at the meeting at that moment in time. He said, however, that he had not been asked to put together a brief of the relevant documents sent and received the previous summer in advance of the meeting. He was adamant, which almost everyone in attendance confirmed, that he made three critical statements to his partners:

(1) Gottlieb had misled them on three separate occasions.

(2) If this were Deloitte U.S., they “would have been out of there by then”, i.e. the relationship with Livent would have been terminated.

(3) He, Chant, thought that the Firm should be out of “here” and he took his leave, somewhat in a huff.[^140]

[216] Chant was firmly of the view that Deloitte had been lied to and that the Put had been removed from the Master Agreement to intentionally deceive Deloitte back in August.[^141]

[217] After Chant left the meeting, the remaining partners fashioned a plan to investigate the matter further. They decided that Barrington and Power would immediately meet with Drabinsky, Richmond would meet with Emerson to fill him in and Cobb would meet with Cooper.

[218] Chant, the one member of the team who had any continuity with the client on this and other issues, was for all intents and purposes excluded from any further discussions over the next few critical days. He was not asked for any further input or for copies of his desk file, which I was told was a shadow file kept by individual technical and audit partners on matters for which continuity and instant access were important, if not essential. Similarly, no one contacted Wardell for his take on this recent revelation or for copies of his desk file.

[219] Barrington and Power’s meeting with Drabinsky proved, in my view, less than fruitful, if not unsatisfactory. First, as one might have expected, Drabinsky expressed, if not feigned, ignorance of the entire matter. Gottlieb was then summoned to the meeting where he provided the following explanation, which raised more questions than it answered:

Myron agreed that there was a side agreement but it was only temporary, a bridging situation. He said that when he talked to Cooper about removing the put, Cooper agreed that they didn’t need it but that he couldn’t make the decision on his own, that it would have to go to his CEO for clearance. Therefore he suggested the temporary side agreement to protect himself.

Myron said that Cooper came back to him later and said that he had received clearance and said “the agreement doesn’t exist; it was never there; so tear it up”. So Marvin [sic] tore it up "it was as simple as that, I swear to God". We will now get documentation of this position from both sides.

Tony advised Bruce Richmond before he met with Gar Emerson, the chairman of the audit committee, later that evening.

Apparently on the Dundee side, they unloaded on Bob Savaria for disclosing the confidential agreement.[^142]

[220] I was told, as well, that Emerson met with Richmond that night, after Barrington and Power had met with Drabinsky and Gottlieb. While there is some confusion in Emerson’s evidence about that meeting,[^143] it would appear that Richmond provided him with the “Gottlieb explanation”, which could only have come from a recitation of the above excerpted phone message. (In a subsequent phone conversation between Gottlieb and Emerson, the same tale was repeated yet again.) Emerson was told by Richmond that Deloitte hoped to receive a confirmation letter from Goodman that the Put was no longer operative. Pending receipt of that letter, Deloitte was content with the explanation that Gottlieb had given to Barrington and Power. Emerson recommended that Smith Lyons prepare an agreement stating that the Put was no longer operative from that date forward. I reserve comment about the value of such a suggestion and how it might impact the fact that the Air Rights revenue had already been recognized and announced publically in Q3.

[221] I was also told, as a wee bit of hearsay evidence—presumably as part of the narrative—that Cobb heard from Cooper that the Put was no longer operative, notwithstanding what Cooper had told Savaria a scant two days before. I would hasten to observe that it made little sense to me why Savaria was not at the Cobb-Cooper meeting on the night of the 3rd simply to confront him with the elements of their previous discussion, which, from any reckoning, had to give lie to what Cobb was being told that night.

[222] I also note that Savaria appears to have been upbraided by someone at Dundee, presumably Cooper, for breaching a confidence by disclosing a copy of the Put to the Livent auditors, which started this whole chain of events. This action again underscores the Vince Lombardi adage about the “best defence”, but more to the point, demonstrates the symbiotic relationship between Dundee and Livent and the fear Chant articulated on his discovery that such a relationship would drive the agenda on the supposed investigation of the newly discovered Put.

[223] Returning now to the Deloitte “plan”, apparently and incredibly, Barrington and Power were satisfied with Gottlieb’s explanation. Barrington went back to the office and either that night or the next morning, Saturday the 4th, crafted six pages of talking points for his next meeting with Drabinsky and Gottlieb. He also planned a meeting with Russo and Messina to finalize certain remaining audit issues.[^144]

[224] I have reviewed the Barrington Memo and Barrington’s evidence several times. I am more than satisfied that this memo was prepared as a “go-forward” memo. In other words, I am not persuaded that it was prepared simply as an outline for a further review of the Put issue and to but receive confirmation or further confirmation that the Put was “finally” dead—for at least the second time. The memo is divided into several parts: First, a discussion of Deloitte’s business philosophy and how Livent’s business practices and financial reporting did not live up to the standard that Deloitte expected of its clients; second, a list of the terms on which Deloitte was prepared to continue its relationship with Livent; third, a list of the steps that had to be taken for Deloitte to accept that the Put had been eliminated; fourth, finalization of various 1997 year-end accounting issues; and fifth, a review of the previous year’s debate about whether revenue from the Air Rights sale could be recognized in Q2.

[225] My conclusion that Barrington’s memo reflected the terms on which Deloitte would continue working with Livent, rather than a plan to seriously investigate management’s past misconduct to determine whether it warranted ending the relationship, is supported by the meetings with management that subsequently occurred. The first meeting was between Barrington and Power and Drabinsky. Drabinsky told Barrington and Power that Gottlieb was going to be marginalized once a new investor came on board. The next meeting was attended by the rest of the senior team, including Russo and Messina, to close the loop on some of the outstanding 1997 issues. In my view, the plan for the elimination of the Put—which was just that: a plan to eliminate rather than investigate—did not dispel any suspicion of bad faith on the part of Gottlieb, in particular, and Livent, in general, which Deloitte was obliged to do under s. 5135 of the Handbook, set out above. The plan, such as it was, provided as follows:

In order to have us accept the verbal explanation we must:

1. Be provided a copy of the “put” agreement signed on August 15th, 1997.

2. Receive directly a confirmation in writing that the “Put” agreement was canceled by the parties in the third quarter and a copy of this must be provided to Dundee’s auditor.

3. Receive an opinion from the company’s legal counsel that this document does in fact constitute an effective cancellation of the “Put” agreement in the third quarter. Counsel may want to re-issue its letter to you, and provided to us, as part of the 2nd quarter debate.

4. Have full disclosure of all these facts to the Audit Committee in our presence.[^145]

[226] Deloitte took the position that the following events provided it with a satisfactory explanation in accordance with the plan:

1. Barrington and Power were told by Gottlieb that he had ripped up his copy of the Put when Cooper told him it was no longer needed, at an unspecified time and date.

2. Goodman wrote Gottlieb a letter dated April 4th that said the Put agreement had been cancelled sometime in August, a fact which he had not communicated to Cooper because of the “pace of business and travel”.

3. On April 7th, Seyffert drafted an agreement, at Emerson’s request, which effectively said that if the Put (which I conclude he prepared or caused to be prepared on or about August 15th, 1997) were alive, it was now “officially” dead.[^146]

[227] As a further demonstration of the problems with which Deloitte was faced in accepting the word of either of these two clients, the following is the text of a letter Gottlieb sent Cooper on April 7th—the same date as the agreement apparently eliminating the Put:

I understand from Ned that you are upset about the agreement that Ned and I had achieved regarding the cancellation of our PUT agreement. Please be assured that we are positive about the project and wish to retain the good spirit of cooperation between Livent and Dundee.

Accordingly, we wish to confirm that notwithstanding Ned’s letter of April 4, 1998, and the agreement of today, a copy of which is attached hereto, the PUT agreement referred to in Ned’s letter is binding and effective and remains so in favour of Dundee Realty Corporation as if it has never been cancelled.[^147]

[228] For reasons that were never explained in evidence, the Put was memorialized in what appears to be yet another lawyer-drafted agreement, dated the 27th of May, 1998, with but modest word changes from the August 15th version. What is of some moment, though, is the nature and tone of the covering letter enclosing an executed version of the agreement that Gottlieb sent to Goodman:

As discussed last night, I met this afternoon with Michael Cooper and he and I reviewed together the enclosed PUT agreement which is in the exact format as the original. I am forwarding herewith the original agreement as executed by both Michael and myself and I ask that you put this agreement in a sealed envelope in your safe or safety deposit box.[^148]

[229] Finally, and again, for reasons which were never forthcoming, counsel jointly filed one last document that only confounds matters, namely, a letter from Cooper to the late L. David Roebuck, then Drabinsky’s civil litigation lawyer, after the frauds had been discovered, Drabinsky had been terminated and he and Gottlieb had started actions for wrongful dismissal:

This is in response to your letter dated October 19, 1998 (a copy of which is enclosed) concerning the history and current status of what you describe as certain put arrangements between Dundee Realty Corporation (“Dundee Realty”) and Livent, Inc. (“Livent”).

This letter will confirm, as Mr. Ned Goodman did in his letter to Myron Gottlieb dated April 4, 1998, that both (i) “Dundee’s Put” to Dundee Realty (Victoria-Shuter) Corporation (“Victoria-Shuter”) referenced in the Term Sheet dated May 22, 1997 between Dundee Realty and Livent and (ii) the executed Put Agreement dated August 15, 1997 among Dundee Realty, Livent and Victoria-Shuter (which is included in Dundee Realty’s closing binder for the Pantages Theatre at Tab 20) were cancelled pursuant to an oral agreement made in August 1997 following the Pantages Theatre Project closing on August 15, 1997.

This letter will also confirm that, notwithstanding both (i) an April 6, 1998 letter from Livent to me regarding these put arrangements and (ii) a Put Agreement dated as of May 27, 1998 among Dundee Realty, Livent and Victoria-Shuter (referenced in my letter to David Maisel of Livent dated August 18, 1998), there is not now, nor has there been since the cancellation referred to in the preceding paragraph, any legally binding or effective put or agreement with similar effect between Dundee Realty and Livent or Victoria-Shuter regarding the Pantages Theatre Project.[^149]

[230] While it is not necessary for me to speculate about the legal status of the on-again, off-again Put, at least in October 1998, particularly since neither Drabinsky nor Gottlieb was prosecuted in respect of this transaction, the revenue was backed out completely on the re-audit because of the “uncertainty of the status of the put”.[^150]

v. Conclusion on the Put Investigation

[231] As I daresay is evident from my narration of the events from April 2 to April 7, I have concluded that the Deloitte plan to deal with the “elimination” of the Put fell well short of reasonable, both in terms of its design and its execution. During argument, Mr. Fleming tried to persuade me that so long as a plan was “reasonable”, it need not meet perfection in order for an auditor to discharge its obligation under GAAS. That proposition is, in itself, unexceptionable. I cannot, however, accept that an auditor discharges its obligation simply by identifying the risk and making what it considers are appropriate plans to deal with the identified issues. In my view, minimally, more is required under ss. 5135.12 – .14 of the CICA Handbook. Furthermore, the plan in itself must be reasonable in the circumstances—which I find the Deloitte plan was not.

[232] As well, once the Put was uncovered and it led to the suggestion, if not implication, if not conclusion, that Deloitte had been lied to the previous August, then Deloitte was under an obligation to obtain adequate audit evidence to dispel the suspicion that a fraudulent act had occurred. In that respect, Deloitte was obliged to assess all the evidence available to it at the time and to determine whether or not there was “completeness and truthfulness of representations made and about the genuineness of accounting records and documentation”.[^151]

[233] On April 3, Deloitte knew that management, at its highest level, was involved in a fraud, and therefore the assumption of management’s good faith was, by definition, contradicted. Indeed, it might very well have been that the integrity of another client was called into question and therefore, notwithstanding the close relationship of Dundee with Deloitte, the latter had to be mindful that the former might have been complicit in the activities and actions of Gottlieb. I am persuaded that Deloitte, save for Chant, paid only lip service to the fact that its professional skepticism should have been at the highest level.

[234] In summary, I would note the following points which lead me to conclude that Deloitte’s investigation of this issue fell well short of generally accepted auditing standards and its legal standard of care:

(1) At no time did anyone at Deloitte collect all the paper touching on the matters in issue for purposes of reviewing the same from start to finish. These documents were readily available to several of the Deloitte partners and no one assumed or was directed to assume the initiative to do a bare-bones analysis of the paper itself.

(2) Had the August 15, 1997 Put agreement been reviewed by an auditor with a modicum of professional skepticism, he or she would have seen that the document itself gave lie to everything that had preceded its creation. In the first place, it incorporated by reference the Master Agreement, which suggests that it was prepared by a lawyer at or about the time that the Master Agreement was executed, most probably someone from Smith Lyons. This fact supports Chant’s suspicion that the Put was not “intentionally deleted” but was put into a separate confidential agreement to deceive Deloitte.

(3) In addition, the fact that the side agreement contained a confidentiality provision would underscore that the parties intended to keep it away from the eyes of the auditor to further the deception. So why did Deloitte not ask for a copy of the closing book that Livent received in September 1997 for purposes of comparing it to the one seen by Cressatti? Deloitte would have uncovered the fact that the Put was not in the closing book but formed part of a separate attachment sent to Livent by one of Seyffert’s staff.[^152]

(4) I did not receive a valid explanation as to why Savaria was excluded from the meeting with Cobb and Cooper on the 3rd. Savaria was the partner who had been given an explanation from Cooper as to why the put was “alive and well” and being relied on by Dundee Realty from a GAAP point of view. Cooper’s explanation to Cobb during that meeting, therefore, would have made little or no sense since it was at odds with what he had previously told Savaria.

(5) Gottlieb’s explanation to Barrington and Power made no sense, whatsoever. First, as I indicated above, it raised a series of other questions, including, when and where the suggested conversations with Cooper took place, why Cooper then took the position he did on the 2nd, and when, for how long and why the Put had to remain secret, and in a separate agreement.

(6) Deloitte never determined when the Put was allegedly ripped up. In my view, as a minimum, even if Deloitte believed this tale they were obliged to assess the timing of its destruction, if only to determine whether or not the revenue recognition should have taken place in Q3 or Q4, or in 1998. This issue was never analyzed. The only evidence I heard was from Barrington that the revelation of the Put meant that Deloitte had wasted a good deal of time debating the Q2-Q3 issue, in the first place, which was an issue which paled in comparison to the “big lie”.

(7) The best that can be said about Deloitte’s investigation is that it appeared to have been an audit by conversation, which gives rise to all manner of GAAS deficiencies. Unfortunately, the conversations were held with people whose veracity was seriously in question. Therefore, better audit evidence was mandated in the circumstances. Had there been continuity in the team, with even Chant being part of the investigation, he or Barrington should have remembered that either or both of them had been misled, if not lied to in conversations they had with Cooper and/or Seyffert on or about the 26th and 27th of August, 1997.

(8) The letter from Goodman on April 4th did not dovetail at all with what had transpired in late August. Nor with Cooper’s stated position with Savaria on the 2nd as it related to a consolidation of Dundee Realty statements with those of Pantages Newco. It seemed, again, as Chant suggested, that Deloitte was prepared to accommodate, if not Livent, then another of its major clients, Dundee Bancorp.

[235] In my view, if s. 5135 of the Handbook were not enough to require greater diligence in the planning and execution of an investigation into the newly discovered Put, the Deloitte Manual set a standard which the Firm’s actions in the first week of April 1998 did not measure up to:

23.15 If a representation by management is contradicted by other audit evidence, we should investigate the circumstances and, when necessary, reconsider the reliability of other representations made by management. We need to ensure that our reliance on management’s representations relating to other aspects of the financial statements is appropriate and justified.

23.16 We should also consider the implications of fraud and significant error in relation to management’s representations. The implications of particular instances of fraud or error that we have discovered will depend on the nature, concealment (if any), and level of management or employee involved.[^153]

vi. Other Matters—1997 Audit

[236] If I am wrong in concluding that Deloitte’s conduct fell below the applicable standard as of April 4th, 1998, if not in Fall 1997, as previously concluded, I am at a loss to understand how Deloitte could have signed a clean audit opinion for 1997 as it did in the weeks subsequent to revisiting the “transaction from hell”, as Barrington labelled the Air Rights revenue recognition fiasco.

vii. PPC

[237] The same concerns I raised with respect of the audit work in 1996 were repeated in 1997. First, Russo acknowledged that the audit only tested the first three quarters of 1997, which from all accounts amounted to an inadequate review. Secondly, while little would be accomplished drilling down to the core as was done by Mr. O’Kelly in his cross examination of Russo and in his written argument, I think the matter can be distilled to one unassailable fact: Deloitte was prepared to accept and sign off on the final numbers put forward by management for PPC prior to the Audit Committee meeting of April 9th, 1998, some few days after the Put fiasco. At that meeting and for the first time, Gottlieb tabled a list of proposed PPC write-downs, all being put forward in exactly the manner objected to in the previous week’s Barrington Memo, namely, disclosure by ambush.

[238] Simply put, management was recommending, at the request of the Furman-Ovitz group as a pre-condition to their share purchase, that PPC be written down by $27.5 million, or by roughly by 29%. How Deloitte could have reasonably concluded that the inclusion of the $27.5 million was accounted for in accordance with GAAP and that the statements before the proposed write down would “present fairly, in all material respects, the financial position of” Livent as at December 31, 1997 left me breathless. Put otherwise, Deloitte was prepared to sign off on the statements before and after the write down, even though Power told me, the write down was a “step in the right direction”.[^154] In fact, Emerson must have found the whole process a little unsettling since he deferred approval of the statements by the Audit Committee pending a further review by Deloitte.[^155] Russo thereupon went back to Toronto and re-worked the numbers by applying them on a show by show basis, a step which had not been undertaken at first instance.

[239] How this last minute adjustment, which created a huge loss for the year, in respect of a hot-button item such as PPC, coming on the heels of the Put fiasco did not cause Deloitte to put the brakes on the entire audit process is beyond my comprehension. Why these issues alone, together with the fact that management insisted yet again on bringing five other “unusual” Revenue Transactions into income, did not cause Deloitte to rethink every representation made by management, causes more than modest concern about the entire audit for year-end 1997, if not before. In arriving at this conclusion, I have not thrown the other matters into the mix which, as O’Kelly argued, should have raised more red flags, in which category I include additions to fixed assets and their testing, accounts payables testing and sampling and unrecorded liabilities. And in that regard, I have not expressed my concerns about the fact that the representation letter provided Deloitte for the year was signed by Gottlieb and Drabinsky and not by Banks and Messina, which would have been more normal and expected.

[240] Putting the matter otherwise, even if Deloitte somehow escaped an adverse finding in respect of the Put issue in April 1998, I am satisfied that it would have been obliged to withhold a clean audit opinion for year-end 1997 in respect of PPC, the Revenue Transactions, and the ancillary issues described above. Simply put, the Firm’s professional skepticism, while at an acknowledged all-time high, would have mandated a wholesale investigation, and not simply an audit on those matters, which would have placed them on a collision course with Gottlieb and Drabinsky.

9. Tort Claim—Conclusion/Distillation

[241] Where am I, now that I have canvassed the Livent-Deloitte waterfront? I have first concluded that Deloitte should have pulled the plug on its relationship with Livent at the end of August or, at the very latest, September 1997. In my view, had matters come to a head on either of those two dates, then Deloitte would have been obliged to make “full and frank” disclosure not only to the Audit Committee but to the regulators, the results of which would have put Livent in the position it found itself in 11 months hence.

[242] In the alternative, if I am wrong in that conclusion, based upon the matters distilled in the judgment to that point, I am of the opinion that Deloitte should not have signed off on the 1997 Audit in early April 1998. The events of that month and the weeks leading up to the Put rediscovery, if not the massive proposed PPC write-down illuminated by the foot-lights of the New York Audit Committee meeting gave new meaning to the adage “once burned, twice shy”.

10. Breach of Contract—Conclusion

[243] Returning but briefly to the commencement of these reasons, because of the manner in which this case was presented on both sides of the aisle, I indicated that the review would focus on the tort aspect of the claim as opposed to the fact that the action is also founded in contract. I am satisfied that the action in contract succeeds similarly and for the reasons expressed above. No distinction will therefore be made on the elements of the contract and its breaches, all of which are incorporated by reference to the finding of “negligence” described above. Not that it was argued in that vein, but I do not believe that it is necessary for me to find that the caveat found in the standard engagement letter set out at footnote 76 above acts in any way as a limiting or exclusionary clause relieving Deloitte of its contractual duty in respect of the detection and resolution of intentional misstatements.

Part II: Corporate Identification Doctrine

1. Introduction

[244] Deloitte takes the position that even if I were to find negligence or breach of contract on the part of the Firm, Livent’s losses are not recoverable because such were caused by its own illegal acts. This proposition, otherwise described as the “corporate identification doctrine”, arises out of what Professor MacPherson observed is rather “unsettled law”, which he also argues is “in need of rationalization”.[^156]

[245] This doctrine, and the principle of ex turpi causa non oritur actio, achieved more than some prominence during the course of argument. I think it is also fair to say that the ultimate conclusions expressed below in respect of the application of the two doctrines to the facts of this case were not arrived at lightly, but only after repeated reflections on the parties’ respective arguments and the case law cited. I am also not naïve enough to think that the issue will not receive further consideration by other courts in this continuing saga.

2. Genesis of Corporate Identification

[246] Professor MacPherson, who has written on the doctrine,[^157] notes that the “identification doctrine was created as a device to ascribe or attribute a mental state to a corporate body for the purposes of civil or criminal liability. The original application of the identification doctrine was as a means to hold a corporation liable.”[^158]

[247] He made a similar, if not clearer, observation about the genesis of the doctrine in an article in the Canadian Business Law Journal:

Identification theory is the manner in which a corporation is held liable for actions that are not amenable to vicarious liability. This includes crimes requiring proof of mental fault – mens rea or negligence – … or torts requiring actual fault or privity of the corporation … . Once the application of the theory is established, then the actions and mental states of the human individual who is “identified” with the corporation become those of the corporation. As one judge has put it, the human being becomes the “embodiment” of the corporation … . Even though the individual and the corporation “become one” when the identification theory is applied, the individual can generally be convicted in addition to the corporation … .

[248] The two seminal cases which provide the underpinning for the doctrine of corporate identification, he suggests, are Lennard’s Carrying Company, Limited v. Asiatic Petroleum Company, Limited[^159] in the civil context, and Canadian Dredge & Dock Co. v. The Queen[^160] in the criminal law arena. Both cases arise in circumstances where the Court created fact-specific criteria to determine when and under what conditions a company should be responsible at law for the acts of its directing mind.

[249] Neither case dealt with a situation where the doctrine was sought to be applied in an action by the “aggrieved” company against a third party who allegedly missed or failed to uncover the wrong doings of the company’s directing mind. The first Canadian case that seems to have dealt with an action against a third party and the applicability of the identification doctrine was Hart Building Supplies Ltd. v. Deloitte & Touche,[^161] a case which I will discuss below.

3. Deloitte’s Position

[250] Deloitte’s position is that the frauds of Gottlieb and Drabinsky must be attributed to Livent under the identification doctrine developed by Estey J. in Canadian Dredge, which is succinctly stated in that judgment as follows:

[T]he identification doctrine only operates where the Crown demonstrates that the action taken by the directing mind (a) was within the field of operation assigned to him; (b) was not totally in fraud of the corporation; and (c) was by design or result partly for the benefit of the company.[^162]

[251] The defendant submits that Drabinsky and Gottlieb were the directing minds of Livent, that they were acting within the scope of their authority and assigned functions, and that they undertook the frauds discussed above to maintain, among other things, Livent’s access to the capital markets and ensure a continuous flow of money to the company. Deloitte agues, as it did in Hart Building, that once the criteria set forth by Estey J. are met, then attribution to the corporation is established and the defence prevails.

[252] While I do not take issue with the proposition that the formula has been met in the instant case, I am not sure that Estey J. intended that it be applied in circumstances other than as “a court-adopted principle put in place for the purpose of including the corporation in the pattern of criminal law in a rational relationship to that of the natural person”.[^163] If that statement were not sufficient to limit or clarify the application of the doctrine, Estey J. made this further observation:

The identification theory was inspired in the common law in order to find some pragmatic, acceptable middle ground which would see a corporation under the umbrella of the criminal law of the community but which would not saddle the corporation with the criminal wrongs of all of its employees and agents.[^164]

[253] Indeed, I believe it is now well accepted that cases like Canadian Dredge were not intended to create universal attribution rules that can and should be applied mechanically, as Deloitte postulates, regardless of the context. Such a view runs counter to the excerpt from Estey J.’s decision, as well as the oft-quoted decision of Lord Hoffmann in Meridian Global Funds Management Asia Ltd. v. Securities Commission:

The company’s primary rules of attribution together with the general principles of agency, vicarious liability and so forth are usually sufficient to enable one to determine its rights and obligations. In exceptional cases, however, they will not provide an answer. This will be the case when a rule of law, either expressly or by implication, excludes attribution on the basis of the general principles of agency or vicarious liability. For example, a rule may be stated in language primarily applicable to a natural person and require some act or state of mind on the part of that person “himself,” as opposed to his servants or agents. This is generally true of rules of the criminal law, which ordinarily impose liability only for the actus reus and mens rea of the defendant himself. How is such a rule to be applied to a company?

One possibility is that the court may come to the conclusion that the rule was not intended to apply to companies at all; for example, a law which created an offence for which the only penalty was community service. Another possibility is that the court might interpret the law as meaning that it could apply to a company only on the basis of its primary rules of attribution, i.e. if the act giving rise to liability was specifically authorised by a resolution of the board or an unanimous agreement of the shareholders. But there will be many cases in which neither of these solutions is satisfactory; in which the court considers that the law was intended to apply to companies and that, although it excludes ordinary vicarious liability, insistence on the primary rules of attribution would in practice defeat that intention. In such a case, the court must fashion a special rule of attribution for the particular substantive rule. This is always a matter of interpretation: given that it was intended to apply to a company, how was it intended to apply? Whose act (or knowledge, or state of mind) was for this purpose intended to count as the act etc. of the company? One finds the answer to this question by applying the usual canons of interpretation, taking into account the language of the rule (if it is a statute) and its content and policy.[^165]

[254] The analysis in Lennard’s—the case in which Viscount Haldane L.C. coined the phrase “directing mind and will”—is